Index Tail, Fund Management Dog

The increase in the minimum free float required for eligibility for FTSE’s UK index series, announced this week, is undoubtedly a reaction to growing concerns over corporate governance.  FTSE has been careful to appear as neutral as possible in making the rule change: consulting a broad range of clients before increasing the minimum float level, while also making it clear that the consultation process itself came in response to requests from those index users.

As a result of the change, UK-incorporated companies seeking to gain entry to the index provider’s UK index series must have a minimum 25% of freely traded share capital.  Before, a free float of as little as 5% would have been sufficient for some larger-capitalisation companies to gain inclusion in the FTSE All-Share and FTSE 100.

According to a report in today’s Financial Times, the changes haven’t gone far enough for some investors. The UK’s National Association of Pension Funds, which represents funds with collective assets of £800 billion, says that the minimum free float threshold should be set at 50%.  If this higher free float minimum were imposed, says the NAPF, minority shareholders would be able to block a majority shareholder’s resolution (assuming they all voted together).

This response reveals that what appears to be quite a technical issue has much wider relevance than we might imagine. Let’s try to spell out some of the conflicting economic interests at play.

First, FTSE’s role in developing and maintaining indices is not necessarily aligned with the incentives of its new owner, the London Stock Exchange (and the same goes for other exchange-owned index providers). FTSE promises to compile benchmarks objectively and without bias.  Creating the index rules, however, means setting some minimum standards on tradeability.

The LSE, on the other hand, is interested in obtaining revenue from listings and therefore has a natural bias to encourage as many foreign companies as possible to have their shares traded in London.  The UK regulator, the UK Listing Authority (UKLA), has also so far taken a liberal view on listing requirements, presumably because it takes a similar view and wants to encourage companies to shift their headquarters to the UK.

“Isn’t it odd that FTSE now sets a higher minimum free float requirement than the regulator?” Mark Makepeace, FTSE’s chief executive, was asked on a conference call yesterday by a journalist.  “You should ask the UKLA,” Makepeace responded.  Makepeace also insisted that FTSE’s policy committee, which sets index rules, will remain completely independent from the LSE.

Second, there’s an obvious conflict between the interests of companies looking to gain index access and attract capital from the growing pool of tracker funds (i.e., to sell their shares for as high a price as possible) and the interests of investors buying those funds (who want to buy as cheaply as possible).

Whether or not a small free float contributes to greater potential price distortions as a result of index inclusion is an important additional question, and a difficult one to answer. In principle, the free float adjustment which most index providers now use as standard (reducing the weight of a company in the index by a factor reflecting the proportion of that company’s share capital that is not traded) counteracts the natural supply/demand imbalance that would occur if you had a lot of index funds chasing a small number of liquid shares, forcing up prices.

On the other hand, the lower the absolute level of free float, the greater the chance of “accidents” occurring, even if indices are adjusted to reflect the number of their constituents’ shares that are tradeable.  This is particularly true when changes in economic interest can easily be conducted behind the scenes and via derivatives contracts. The massive short squeeze of 2008 in Volkswagen shares, which severely distorted the DAX index and which involved both a small float and derivatives-based buying, is an obvious case in mind.

It’s important not to be naive about companies’ motivations for wanting index inclusion.  Of course they want to boost their share prices, even if only on a temporary basis (to allow some shareholders to cash in).  And it’s not just a question of nefarious oligarchs from the former USSR seeking access to the pool of capital widely tracked indices can guarantee, even if that makes good headlines and many companies  from that region cite this as a key motivating factor for listing in London.

Given the importance of passive investing, while index providers go to great length to compile benchmarks that can actually be tracked, they do not provide any assurances about the quality of the companies they are admitting, something it’s easy to forget. Remember Polly Peck, Maxwell Communications, Baltimore Technologies, Marconi, or RBS? All are one-time FTSE 100 companies that soared and then crashed.  The fund managers buying those companies and getting burnt were the ones at fault for not doing their homework, not the index provider.

But passive investors are unable to make judgement calls of this type, since they buy all the index shares as a matter of course.  Those investors should take particular care, in other words, and not just buy index funds or ETFs blindly because they appear cheap on a headline basis.  The portfolio of shares or bonds you’re accessing via an index should make sense as an investment in its own regard.  You mustn’t let the index tail wag the fund management dog.

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