Narad Speak  Stock Ideas

Analyst Meet  Leader Speak  Latest Results

Feedback :  Trading Queries info@5pmail.com  DP Queries dp@indiainfoline.com

March 22, 2002

Free Float Index...Mark Make-s-peace on issue

The Bombay Stock Exchange is debating on the idea of free-float applicability to its wide range of indexes, including the heartbeat of the capital market- the Sensex. About a year ago, the BSE launched the country's first free-float index- BSE TECk Index, which constituted of TMT stocks.

The BSE believes that any change, especially dealing with the Sensex needs to be well-planned, discussed and deliberated upon. In this connection, the Bombay Stock Exchange organized a Round Table On Free Float Index which was chaired and moderated by Mark Makepeace, Chief Executive, FTSE, London.

Speaking to India Infoline, Mark Makepeace said he was optimistic that the capital markets would be convinced of the need to go in for a free-float. Though he refused to comment on the time-frame the Indian markets would take, the expert panel was of the opinion that a six to twelve month time frame was good enough for the markets to adjust to the change.

The panel speakers at the Round Table included Nagendra Parakh, Chief General Manager, SEBI, Bharat Shah, CIO, Birla Sun Life AMC, Ajit Surana, Member, The Stock Exchange, Mumbai, UR Bhat, CIO, Jarding Fleming Mutual Fund Asset Management, Vineet Bhatnagar, MD, Refco India, Krishnamurthy Vijayan, CEO, JM Mutual Fund and Manoj Vaish, Dy Executive Director, The Stock Exchange, Mumbai.

In his inaugural address, AN Joshi, Executive Director, The Stock Exchange, Mumbai said Free-Float methodology is fast emerging as a global best practice in the index construction. The objective of the debate was to generate a debate amongst the Indian market participants, mutual funds, FIIs and also regulatory agencies on issues relating to the applicability of the free-float to stock indices in India, especially the Sensex.

So what is a free float? Though there is no global definition for the term, it can be described as that portion of equity capital of a company that is held by non-promoters and thereby available for trading by investors. The free-float typically excludes the equity held by promoters, their associates, government and stakes of foreign holders.

Dr. Manoj Vaish, Dy Executive Director, BSE, said change must be cautious, well-planned and backed by consensus. Bharat Shah of Birla Sun Life advocated that even if the entire Sensex needed an overhaul, it should be done. Nagendra Parakh was of the opinion that there was no need for adjusting the Sensex to suit the fund managers. He added that the volume of trade is not beyond 1% of the market capitalization.

The consensus, however, was that certain issues like historical data, format for quarterly disclosure of shareholding pattern, cross-ownership   etc need to be addressed before such a change is implemented. The panel also advocated the use of Bands and felt a lead-time of around six-months to one year would lead to a gradual shift which would enable fund mangers to rebalance their portfolios with lower turnover and impact costs.

Also read...

• What is a Free-Float based Index?

• Why do Index Funds prefer a Free-Float Index?

• Why a Free-Float based Index?

• Issues in implementing Free-Float

• Free-Float concept in India

What is a Free-Float based Index?

An equity index that is calculated using only the free-float market capitalization of its constituent companies is known as a free-float based index. Presently, all equity indices in India, except the BSE-TECk Index, are calculated using the 'full-market capitalization' methodology. The 'full market capitalisation' methodology considers the total number of issued shares by the company for computing the index. On the other hand, a free-float methodology (also called modified market capitalization methodology) includes only those shares that are readily available in the market for purchase by investors. These shares are called free-float shares. Thus, the market capitalisation of a large closely held company in a free-float based index would be significantly reduced. Free-float may be defined as that portion of equity capital of a company that is held by non-promoters and thereby available for trading by investors. The free-float typically excludes the equity held by promoters, their associates, government and stakes of strategic holders.

Source: BSE

Why do Index Funds prefer a Free-Float Index?

Index Funds adopt a passive investment strategy. Their strategy involves purchasing, holding and adjusting a basket of stocks in order to replicate the performance of a reference benchmark such as the BSE-SENSEX in India and the S&P500 in the U.S. The objective is to match the returns of the index, not to outperform it.

Index Funds tracking a full-market capitalization weighted index may find difficulties in replicating the index. Due to sensitivity of price movement of closely held companies, inclusion of such companies in the index may lead to higher impact cost for index funds. In an extreme case, full market capitalization weighted indices may be forced to keep closely held blue chip companies out of the index in order to maintain their index investability. In such a situation, shifting to free-float methodology would not only lead to improving the benchmarking characteristics of indices but will also facilitate inclusion of closely held companies in the indices.

Source: BSE

Why a Free-Float based Index?

A free-float based index is regarded as a better benchmark in comparison to a full market capitalisation weighted index as it aids both active and passive investing styles. It aids active managers by enabling them to benchmark their fund returns vis-à-vis an investable index. This enables an apple to apple comparison thereby facilitating better evaluation of performance of active managers. Being a perfectly replicable portfolio of stocks, a free-float adjusted index is best suited for the passive managers as it enables them to track the index with minimum tracking error.

Internationally, all the major index providers have shifted to free-float based indexing. In India, BSE took a lead in introducing the concept of free-float by launching the country's first free-float based index, the BSE TECk Index last year. Even in the emerging markets, the huge amount of funds indexed to the free-float adjusted MSCI indices is a testimony to the acceptance of the concept of free-float by all major market participants. The increasing flow of funds from the developed markets to the developing markets has necessitated and accelerated the process of constructing and maintaining indices based on internationally accepted free-float methodology. Following are the major reasons for moving to the free-float methodology:

• Higher levels of indexation require that an index represent accurately the investable market capitalization.
• Need to avoid distortions that make the index hard to track.
• Minimising market impact of index fund flows.
• The general perception that lack of free-float factors causes market inefficiencies

Source: BSE

Issues in implementing Free-Float

• Definition
  The Free-Float seeks to identify the amount of shares for a stock that are readily available to investors for investment. Typically, in case of a company, there are portions of its paid-up equity that are virtually locked with entities like the government, promoters, and promoter's associate companies, directors, employee associations etc. These portions of the company's equity are normally closely held and are not available for buying in the market. The free-float for a company is thus the total equity less these closely held portions. Global Index providers like FTSE, MSCI, S&P, STOXX etc. have fine tuned the above definition to define free-float as the equity of a company available to international investors. This is justified since in many emerging markets restrictions of foreign ownership often make the actual free-float less than what is apparent. The definition of free-float assumes importance especially in context of its implementation since discerning the exact free-float of a company is not easy.

• Cross-ownership
  Cross-ownership refers to the stakes held by index companies amongst other index companies. Cross ownership is widely prevalent in the emerging markets. This can be gauged from the fact that in the Hong Kong's premier benchmark index - Hang Seng 33, 17 of its 33 constituents have cross ownerships. Even in BSE-SENSEX, 7 index companies hold stakes in other index companies. The issue of cross-ownership has to be addressed to avoid overstating the market capitalisation of a company and hence its investibility. For instance, in the BSE- SENSEX, Reliance Industries Ltd. holds around 30% in BSES Ltd. However, for the purpose of calculation of the index the entire market capitalisation of both the companies is considered. Once the concept of free-float is implemented in index construction, such mutual stakes would be deducted to arrive at the true investability of a stock.
  
  Disclosure of Shareholding by Companies

The format in which the companies disclose their shareholding pattern is the single most important determinant in discerning the true free-float of companies. Presently, as per SEBI guidelines, companies are required to furnish their shareholding pattern on a quarterly basis to the stock exchanges. The current format of disclosure, however, does not adequately address the issue of discerning true free-float in the requisite manner. A number of companies like ACC, SBI, L&T, ICICI, BSES, ITC etc. report their Non-Promoter Holding as 100% while it a common knowledge that large holdings in these companies are held by strategic investors and hence cannot be considered to be free-float in the true sense.

• Implementation
  There are two main issues in the implementation of free-float weightings in the Index construction.

• Use of Bands or Exact Free-float

(a) Free-float Bands
Instead of considering the exact free-float of each company, which is difficult to calculate, 4 or 5 bands using pre-defined free-float ranges are created. All companies are classified into one of these bands for the purpose of determination of their free-float. The argument for the use of banding system in the implementation of free-float is that it makes the whole concept simple. Discerning the accurate free-float of a company is a tough task, specially, in the light of the present disclosure norms relating to the shareholding pattern of the companies. Thus, the use of bands greatly facilitates the implementation of free-float. FTSE has advocated use of bands instead of exact free-float.

(b) Exact Free-float
The argument for exact free-float is that banding can lead to inconsistent weightings within the same band. For example, a company falling in the lower side of a band and one falling on the higher side of the band would be weighted equally though their investibility would greatly differ. STOXX, S&P and Dow have advocated exact free-float weightings.

• Lead-time for Implementation

Since a lot of money is tied to benchmark indices in the form of index funds, Exchange Traded Funds etc., the transition from full market capitalisation methodology to free-float methodology is generally phased over a period of time called the lead time. This gradual shift to free-float methodology enables fund managers to rebalance their portfolios with lower turnover and impact costs. The Implementation of the free float adjustment by various index providers has been phased differently.

Source: BSE

Free-Float concept in India

The free-float concept was introduced in the country last year by The Stock Exchange, Mumbai by launching a TMT benchmark - the BSE TECk Index based on free-float methodology. Except BSE-TECk Index, all the other Indian indices (including BSE-SENSEX) are currently constructed based on full-market capitalization methodology.

The BSE TECk Index closely tracks the performance of the Information Technology, Media and Telecom sectors through a basket of 21 stocks listed at the BSE. Currently, TMT sector accounts for around 20% of total market capitalisation and around 60% of average daily volume on BSE. The BSE-TECk Index provides a quality benchmark for the investment community in the knowledge-based sectors. The constituents and details of BSE-TECk Index as on March 1, 2002 are as follows:

Source: BSE

Courtesy : India Infoline

Archives