Free float adjustment have recently become the most topical and high profile issue in the world of indices and benchmarks, with the potential changes becoming important for both passive and active investors. The initial focus by independent index providers on extending the use of free float factors in indices came in 1999 when S&P launched its range of global indices that were extensively free float adjusted from inception. In August 1999, FTSE International, after a period of consultation with investors and users of its benchmark indices decided to introduce a broader free float adjustment. However, as FTSE delayed implementation of the change until June 2001 it became for many investors an issue that could effectively be ignored in the medium term.
The use of free float factors was given renewed prominence following the announcement in February by MSCI that they were considering implementing free float weighting factors for both new and existing constituents in MSCI indices. More recently STOXX has decided to use free float factors for all companies in the broad STOXX and EURO STOXX indices and more importantly the narrow blue-chip EURO STOXX 50 and STOXX 50 indices.
The STOXX index changes have become important due to the expected market impact and very short time frame from announcement of the use of free float factors in early July 2000 to full implementation in September 2000. Whilst STOXX indices are not the most widely used benchmark indices in Europe, they have achieved a very strong position within the retail investment market and with fund managers that have recently diversified away from their domestic equity markets.
The push by STOXX with a rapid change to its indices has created a new focus on the issue and MSCI has recently announced a formal consultation process starting in September 2000. MSCI expect to announce a conclusion to this review of alternatives to its full market capitalisation methodology before the end of December 2000.
The STOXX index committee met last month to finalise the changes to the STOXX indices in light of the previously announced changes to the index regarding the use of free float. We believe that the most important impact will be on the widely followed narrow blue chip indices and this will have an impact at the close of 15 September, 2000 when the rebalance become effective.
One side effect of the adoption of free float rules is that apart from leading to significant changes in the weights of existing stocks in the blue chip indices, the change of methodology will also lead to stocks being added and deleted from the index. Overall for the Euro STOXX 50 the rebalance will be equal to 28% of the index, whilst a STOXX 50 fund will be required to rebalance 25% of its portfolio.
Based on data from the end of July we believe that two new companies will enter the EURO STOXX 50 – Danone and San Paolo IMI and two companies will be removed – Metro and Electrabel. In the STOXX 50 we believe that AstraZeneca, BNP and CGNU will be added, replacing ENEL, KPN and Unilever.
Apart from these stocks being removed from the index there is a dramatic impact on other constituents where sizeable weighting factors have been introduced. The most significant stock specific adjustments include France Telecom, where only 37% of its market capitalisation will be included in the index, Deutsche Telecom (41%) Telecom Italia (45%) and Allianz (58%). The main beneficiary from the changes is Nokia, although in the Euro STOXX 50 this is likely to be capped at the maximum 10% of the index.
Although the index impact is likely to be focussed around the index change at the close of September 15, this will reflect activity mainly relating to index funds. Deutsche Banks estimates that there is approximately e50bn tracking the Euro STOXX 50 on a purely passive basis. In continental Europe there are also a large number of active funds that have used the Euro STOXX 50 as their main diversification vehicle. These investors are also expected to adjust their portfolios although they are likely to have a reasonable degree of flexibility with respect to timing.
The STOXX 50 index will also change substantially due to the free float changes, however, this pan-European index is less widely. On a passive basis we estimate that there may be approximately e10bn tracking this index.
The STOXX implementation of free float in a short space of time will give a useful guide to the potential market impact should MSCI implement such a dramatic change to the indices. It is clear that the impact from an MSCI change would be significant due to the fact that it is the leading equity benchmark on a global basis.
Nizam Hamid is director, derrivatives and portfolio trading research at Deutsch Bank in London and is a member of the STOXX indices advisory committee