MSCI - free and floating
Measuring free float has for some time been one of the trickiest and most controversial issues for index providers- how to measure it accurately and to make indices both representative and investible. Just defining what constitutes free float and what weight a company should therefore carry has proved a source of many an argument. Now MSCI, the world’s largest indexing company is joining the club by gradually rebalancing all its indices between now and next May.
Rebalancing will increase market coverage from 60% to 85% and MSCI is setting the parameters somewhere between two of its competitors. Whereas FTSE uses a bracket approach to define available shares and SSSB tries to calculate free float with greater precision, MSCI is taking outstanding shares and rounding them up to the nearest 5%. Deutsche Bank, for example, has 100% of its shares registered as outstanding by MSCI. In fact only 41% float freely and the company will in future be included in the index with 45% of its shares as outstanding.
The transition will take place in two phases. Indices will move half way to the free float by the end of November and to full float at the end of next May. Equally important, according to MSCI executive director Rabbe Ekholm, is the recent launch of a provisional index, a proxy today for next year’s finished product. Once the process is completed in May, the two will be identical and the ‘provisional’ index then becomes redundant.
In practice this means those using MSCI indices can make the changes as they see fit over the next year. Ekholm says the staggered approach should provide transparency and give investors a little leeway and such an analysis has resonance within the industry. Says Sandy Rattray at Goldman Sachs: “this will give fund managers a high degree of choice as to when they implement the changes to their portfolio…this will clearly reduce the amount of impact that the changes have, as trading will likely be dispersed over the 11-month period”. Large funds using MSCI’s indices are more likely to execute the transition in their own time as it is likely to make their trading less predictable.
MSCI chose the “hybrid” system – somewhere between the bracket approach and a precise definition – for good reasons. Under the bracket system, a small change in actual free float can lead to jerky movements in the overall index weighting of a company. Ekholm says they don’t buy the notion that a precise, accurate measure of free float actually exists. In many markets, particularly emerging markets, you have to go through a lot of research to ascertain a relevant free float estimate. “Even then you have to appreciate that there is a margin of error,” he says.
The new rebalanced indices will consider private holdings under 5% as not part of the free float. Some indices ignore as negligible private holdings of under 5% yet Ekholm gives the example of Japan where it is not uncommon for companies trading with each other to have a 1% or 2% shareholding in each other. This may appear insignificant but, so the argument goes, the cumulative effect can be significant. Private, corporate and government holdings of all magnitude will be calculated and therefore reduce a company’s weighting within the index.
Ekholm says that large privatisations, cross-border M&As and a strong growth in the volume of indexed assets have made free float more of an issue over the past decade. Equally important is that other index providers, namely FTSE, Dow Jones Stoxx and SSSB have already adjusted for free float and that those that have yet to are considering it. Ekholm says the primary focus is to adjust the index construction so that the index is still relevant. “Market representation and investibility are our priorities.”
The consequences of readjustment vary according to the quantity of outstanding stocks. Those with low float will have their weightings decreased (NTT, Toyota, France Telecom and Deutsche Telecom, for example) while those with high free float will benefit (Vodafone, Nokia, BP Amoco, Novartis etc). Other companies, among them German car maker Porsche and the UK’s Shell Transport & Trading and Cable & Wireless, will find themselves included in the indices for the first time.
Give the popularity of MSCI indices, rebalancing will for some investors be a serious undertaking, be it in one or two stages. Goldman Sachs estimates that overall turnover in MSCI World may be up to 27% including all the purchases, sales and introduction of new companies. Although these levels are up to 10 years normal index turnover, Goldman Sachs says the market impact is likely to be limited. There will be significant intra country trades but many large scale sales will be countered by equally large scale orders.
Because the two indices are available in tandem for 11 months trading is likely to be more spread out than otherwise might have been the case. Says Rattray: “It appears that, although the changes will generate very high levels of turnover, they may not generate especially high levels of market impact. Speculators should probably be disappointed by this announcement, and passive managers satisfied.”