Does float adjustment help or hinder index investors?
In recent years float-adjusted value-weighting has largely replaced the pure value-weighting of indices. In this article, we try to find out which weighting scheme is more favourable in terms of index properties. We analyse the following "perfect properties" of indices:
- Availability of history
Our conclusion is that pure value-weighted indices tend to exhibit favourable index properties, while many float-adjusted indices fail to improve index practices and, indeed, cause distortions.
The main advantages of float-adjustment are an objective representation of the effective trading opportunities in a market and enhanced liquidity. Nevertheless, there are reasons why pure value-weighted indices may be preferable.
First, float-adjusted indices approximate the relative importance of companies less objectively. Second, float-weighted indices are subject to biases as definitions of free float and the assignment of free float factors are often not sound. Third, although replicability favours float-adjusted index approaches, pure value-weighted indices usually do not suffer from illiquidity in practice as their constituents are required to have a minimum market capitalisation and/or trading volume. Fourth, free float methodologies are often non-transparent as they are incomplete and heterogeneous. Fifth, free float indices are usually not marked-to-market: index providers receive information about holdings with a lag and free float factors are reviewed only periodically. Finally, longer time series are available for pure value-weighted index data.
In our opinion the main disadvantage of float-adjusted indices is that, due to regulatory differences and different definitions of free float, the assignment of float factors is subject to a time lag, resulting in incomparability between different countries and providers and best guesses when analysing data.
An index's weighting scheme is crucial. In the past, market capitalisation-based weighting was popular. Nowadays, float-adjusted value weighting is dominant. In this article, we compare these two weighting schemes. The goal is to find out if one or both weighting schemes leads to more favourable index properties.1
Our article is structured as follows. First, we present an overview of financial indices' weighting schemes, where we focus on the two principal schemes examined in this article. We describe "perfect properties" of an index. In the main part of our article we examine these index properties in detail, analysing which of the two weighting schemes best meets them. Finally, we draw a conclusion.
There are various static indexing strategies. By static, we mean strategies that are buy-and-hold in nature. The resulting index weightings can be based on a variety of criteria, including price, fundamental accounting measures (e.g. dividends or cash flow), trading volumes, or the simple equal-weighting of constituents.
Nevertheless, the most prominent methodology is market-capitalisation-based weighting, also called value weighting. There are several ways of value weighting. First, there is pure value weighting, under which the weight of a constituent is equal to a company's market capitalisation relative to the sum of market capitalisations of all equities in the index. Second, there is float-adjusted value weighting. Free float weighting adjusts the market capitalisation-based weights to reflect only those shares that are publicly available for trading. Strategic shareholdings, such as those of founders as well as corporate or government agencies, are removed. There are other "flavours" of value weighting, involving the capping of the weightings of individual companies or sectors.
To assess the pros and cons of the pure and float-adjusted value weighting approaches we need to define the characteristics of a "good index". Plewka, T. (2003) defines the following substantial key criteria of an index:
- Representativeness: the index should be representative. In other words, the components of the index should match with the portfolio of a representative agent. Put plainly, the index should approximate the performance and risk metrics of the market as objectively as possible.
- Replicability: an agent should be able to replicate the index portfolio; that is, he should be able to take positions in the constituents of the index.
- Transparency: the index must be transparent. This goes along with simplicity and traceability of index baskets and index prices. The composition and the calculation of the index should be known and available at every point in time.
- History: an adequate time series of the index should be available in order to achieve acceptance from the market players. Long time series allow agents to analyse the statistical properties of the index or to identify its relationship with their own portfolio (e.g. via correlation coefficients).
- Up-to-dateness: indices need to be up-to-date. This is of special importance for the operational function of an index.
- Neutrality: market participants have greater trust in a financial indicator when it is calculated by an independent institution. Plewka, T. (2003) refers to this property as neutrality.
- Availability: index data should be available at every point in time and, possibly, free of charge.