The grande dame of indices MSCI looks as if it is about to capitulate to the free float fever. After its earlier annoucement that the topic was no longer taboo, it has with due dignity and a suitable time lapse, come up with alternatives to the full market capitalisation weight approach it has been using.
Its main proposal is to free float-adjust the constituents weights in the indices, but it could base this on 10 free float ranges, it says in its long awaited consultation paper that the group stresses that it is not commited to any course of action.
Looking at the background to the decision, MSCI says the question of being able to invest in securities that had limited free floats was becoming more important, as there have an growing volume of particularly privatisations, as well as major IPOs, which have had relatively limited free float. Also the matter of foreign ownership restrictions , which limits availability of stocks to non domestic investors, has also impacted on the investability issue. It refers to the problems caused to passive investors, often trying to replicate an index, where a stock that need full representation in the portfolio, even though what is available to the market, is well below the representation level at which the stock is being included in the index being tracked.
Should MSCI adopt these proposals, which it claims must not be treated as a foregone conclusion, it says any ‘free float’ must aim to arrive at the proportion of shares that can be considered to be available for purchase on stockmarkets. By definition government holdings, family holdings and controlling shareholders, as well as the stakes managements have, and of holding by other companies have to be excluded.
In Europe, for example, the average free float for different markets vary significantly from 92% in the case of the UK, to 47% in Belgium. For EAFE markets the overall free float is put at 73%, for Europe as a whole 78% (72% without the UK), Japan 65% and North America 94%.
Some of the markets where cross-ownership is a feature the introduction of free float would be beneficial, says MSCI, as it works against double counting the market capitalisations of cross-holdings. But it is acknowledged that using a free float adjustment where companies have only very low proportions available to the public freely is “most important”.
But MSCI points out that is not all on the plus side, as in a number of countries where information disclosure is poor regarding share ownership, so you could end up in a situation where a change could penalise companies with good disclosure regimes. “Free float-adjusting the indices results in a discrepancy between company weights and their actual economic size,” MSCI says.
MSCI proposes having 10 ‘free float ranges’, so that companies with a free float of 10% or above up to 12.5% would be included at 12.5%,a company with15% free float would be included at 20% and so on, with those at 40% coming in at 55%. A company with 75% or above would be included at 100%. There would be transition turnover or around 18% in the case of the MSCI ACWI index.
But it does say that an alternative would be to include each company on a basis that is exactly equal to its free float. While this would be have the advantage of simplicity and full consistency, it does “magnify the issues of quality of information and interpretation”, says MSCI. The transition cost could be around 21% of the ACWI index.
An alternative would be to use expand the present market capitalisation factor to all companies in the index, but this would not solve the treatment of cross holdings, it acknowledges. A third suggestion is to free float above their free float weights.
Regarding the trend to higher concentration of market capitalisation in few enormous companies, which can inhibit indices’ ability to represent a market accurately, the proposal is to increase target market representation to 80% of free floated-adjust capitalisation, says MSCI.
The group goes for a phased-in implementation of the changes rather than the big bang option of single day implementation.
Schroder Salomon Smith Barney reckons that MSCI will go with the banding structure with the 10 bands basis. The firm believes that any changes should be implemented in phases. Commenting on the increase in index representation, SSSB says that the 80% proposal indicates that “MSCI are considering the the constituent selection criteria to take into acount free float”.
Peter Jeffries of Standard & Poor’s in London, says: “There is no doubt but that is the way they have to go. All index providers are going that way. We have always been float adjusted apart from the S&P 500. The concept that MSCI are adopting is one that we accept and endorse.”
He adds: “A number of the indices fom different providers have been badly affected by what has been happening in corporate market with bigger and bigger companies and more privatisations.” Both local and global indices are getting caught by the emergence of these enormous companies, he says.
“One of the ways of reducing the impact and the distortions that a policy of non-float adjustment creates is to float adjust. They are having to do it. Up to now it was not their preferred method, now they have no alternative.” he said.