Free-float Methodology

Concept:

Free-float Methodology refers to an index construction methodology that takes into consideration only the free-float market capitalization of a company for the purpose of index calculation and assigning weight to stocks in Index. Free-float market capitalization is defined as that proportion of total shares issued by the company that are readily available for trading in the market. It generally excludes promoters' holding, government holding, strategic holding and other locked-in shares that will not come to the market for trading in the normal course. In other words, the market capitalization of each company in a Free-float index is reduced to the extent of its readily available shares in the market.

In India, BSE pioneered the concept of Free-float by launching BSE TECk in July 2001 and BANKEX in June 2003. While BSE TECk Index is a TMT benchmark, BANKEX is positioned as a benchmark for the banking sector stocks. SENSEX becomes the third index in India to be based on the globally accepted Free-float Methodology.

Major advantages of Free-float Methodology:

• A Free-float index reflects the market trends more rationally as it takes into consideration only those shares that are available for trading in the market.
• Free-float Methodology makes the index more broad-based by reducing the concentration of top few companies in Index. For example, the concentration of top five companies in SENSEX has fallen under the free-float scenario thereby making the SENSEX more diversified and broad-based.
• A Free-float index 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 the least tracking error.
• Free-float Methodology improves index flexibility in terms of including any stock from the universe of listed stocks. This improves market coverage and sector coverage of the index. For example, under a Full-market capitalization methodology, companies with large market capitalization and low free-float cannot generally be included in the Index because they tend to distort the index by having an undue influence on the index movement. However, under the Free-float Methodology, since only the free-float market capitalization of each company is considered for index calculation, it becomes possible to include such closely held companies in the index while at the same time preventing their undue influence on the index movement.
• Globally, the Free-float Methodology of index construction is considered to be an industry best practice and all major index providers like MSCI, FTSE, S&P and STOXX have adopted the same. MSCI, a leading global index provider, shifted all its indices to the Free-float Methodology in 2002. The MSCI India Standard Index, which is followed by Foreign Institutional Investors (FIIs) to track Indian equities, is also based on the Free-float Methodology. NASDAQ-100, the underlying index to the famous Exchange Traded Fund (ETF) - QQQ is based on the Free-float Methodology.
  
  

What is A Free Float Index?

What is the free float methodology for calculating the weights of different stocks in the index, and how is it different from the earlier market capitalization based method. 

The BSE Sensex shifted to the Free Float Methodology in SEP-2003.This shift to the new method attracted much attention though all the hype and hoopla was hard to understand since the switchover did not change the value of the index nor did it impact to a very great extent the fortunes of the various scrips comprising the index. It is therefore necessary to understand what this change is and what it means. We will also evaluate the impact of this change. 

It is well known that the BSE Sensex is an index comprising of 30 key stocks. Further, the BSE Sensex is a market capitalization based index, i.e. the calculation of the index takes into account the market capitalization of each scrip in the index and the change therein. Moreover, the weight each scrip carries in the index is dependent on the ratio of the scrip's market capitalization to the Index's market capitalization. Thus, under the method prevailing before September 1, the total market capitalization of each scrip was considered for purposes of index calculation. 

Analysts however had a problem with this method. The argument against this method was that a large proportion of the outstanding capital of the company was locked up with promoters, strat egic holders, government, etc and was not available for trading in the market. Therefore, felt market pundits, it would be incorrect to calculate the total market capitalization of a company. It was therefore suggested that the free float method be adopted to calculate the index. The free float method takes into account only that number of scrips that are available for trade in the market. 

To calculate the Index based on the Free Float Method, the BSE assigned Free Float Factors to each scrip. These Free Float Factors determine the percentage of total market capitalization of the scrip that would be taken into account for the purposes of index calculation. For this purpose the BSE has worked out a disclosure format which each company is supposed to submit to the BSE every quarter. The BSE then slots each company into any one of the nine categories it has created. Each of these categories has been further assigned a 'Free Float Factor'. 

The moot question however is what advantage the new method offers. The shift to the new method is considered good because it now truly reflects an investable index. Further, it also removes the influence of a closely held large cap stock on the index. Also, it reflects market movements better and enables passive investing since the index is replicable. 

In fact, this change in the Index methodology directly impacted passive investment vehicles- Index Mutual Funds. The switchover to the new method changed the weightage of each scrip in the BSE Sensex. Since Index Mutual Funds are supposed to precisely replicate the underlying Index, Mutual Fund Schemes based on the Sensex would have been required to sell holdings that have lost weight and buy stocks that gained weight in the Index. 

Such buy and sell activity from Index Fund Managers and from other fund managers using the Sensex as the benchmark should have impacted prices of affected scrips. However, not much impact was observed, particularly on scrips that lost weight, since the momentum of the ongoing rally was very strong. 

The change to the free float method has impacted the weightage of various scrips in the Sensex. Scrips that have gained weight in the index include ACC (Free float factor - 0.9), Bajaj Auto (0.8), Dr Reddy's Labs (0.8), HDFC (1.0), Hindalco (0.8), ICICI Bank (1.0), Infosys (0.8), Larsen & Toubro (0.9), Satyam (0.9) and Tata Steel (0.8). 

Scrips that have lost weight include BHEL (Free Float Factor - 0.4), BSES (0.5), Hindustan Lever (0.5), HPCL (0.5), MTNL (0.5), Nestle (0.5), SBI (0.5), HCL Technologies (0.3), Castrol (0.3) and Zee Telefilms (0.5). The Free Float Methodology is now also being viewed as a global practice. Widely watched and used indices such as the MSCI Index, FTSE, Nasdaq 100 etc make use of the Free Float methodology.

Emerging markets

Emerging markets are nations with social or business activity in the process of rapid growth and industrialization. Currently, there are around 28 emerging markets in the world, with the economies of China and India considered to be the largest.
The FTSE Group distinguishes between Advanced and Secondary Emerging markets on the basis of their national income and the development of their market infrastructure. The Advanced Emerging markets are classified as such because they are Upper Middle Income GNI countries with advanced market infrastructures or High Income GNI countries with lesser developed market infrastructures.

The "Advanced Emerging markets" are:  Brazil,  Hungary,  Mexico,  Poland,  South Africa,  Taiwan.

The "Secondary Emerging markets" include some Upper Middle, Lower Middle and Low Income GNI countries with reasonable market infrastructures and significant size and some Upper Middle Income GNI countries with lesser developed market infrastructures. The secondary emerging markets are:  Chile,  China,  Colombia,Czech Republic,  Egypt,  India,  Indonesia,  Malaysia,  Morocco,  Pakistan,  Peru,  Philippines,  Russia,  Thailand,  Turkey,  UAE.