In the 1990s, index providers started to notice a chasm between the story their benchmarks were telling and the environment investors were dealing with. Not all of the market capitalisation the indices represented was actually available to buy.
Because of this, in the past three years every one of the major index providers has tweaked its products. They have been changed to reflect not just the top quoted companies in terms of market capitalisation, but to show just how much of that share capital is freely floated. On the other hand, provider Schroders Salomon Smith Barney has always used the free float approach as part of its methodology.
FTSE International claims it was the first index provider to make the move to reflect free float in its indices. However, Standard & Poor’s says it was the first, adjusting its Euro and Euro Plus indices for crossholdings as early as 1998.
FTSE says it carried out a consultation with market participants took place in August 1999, which ultimately resulted in the changes FTSE implemented in January 2000.
At the time of that consultation, a resounding 88% of people asked said the FTSE indices should be changed to account for available market capital, says Mark Russell-Jones, regional director of FTSE International in France.
Even if the move did not immediately increase the popularity of FTSE’s benchmarks, the move certainly boosted the company’s image as a pioneer in the index market, he says.
As a result of the consultation, FTSE opted to reflect free-float through bandings rather than weighting the constituent stocks according to the precise amount of freely available capital. Using bandings was a way of reducing turnover in the indices themselves, explains Russell-Jones.
Dow Jones Stoxx, on the other hand, expresses free float in its indices more precisely. But this means there is a lot more turnover, says Russell-Jones, because every time there are slight changes to the free float of a company, the index weighting must be changed. This then means passive fund managers tracking those indices have to readjust their portfolios. “The last thing they want is to pay brokers’ fees every few days,” says Russell-Jones.
Also, bandings allow for the fact that assessing the amount of free float a company is an imprecise science. Asked to give the precise level of market capital freely available to investors for a particular company, different analysts would be likely to give different responses, says Russell-Jones.
Now that the major index providers have all made moved to adjust their global indices to account for free float, is there less to differentiate the benchmark of one provider from that of another?
“They are becoming more and more similar, and I do expect some sort of consolidation in the benchmark market place,” says Commerzbank analyst Dan Fox. “How exactly that would transpire is hard to say,” he adds.
Ultimately it may be the indices which are popular locally that win. “MSCI are popular globally, but less followed in Europe than in the US,” says Fox.
“It’s also the case in Europe that despite the fact there will soon be a common currency, the DAX, CAC and MIB are all closely followed,” he says. That popularity of local indices will continue, he predicts,though even he says this makes little sense.
But most of the index providers say there are still plenty of distinctions between the benchmark products available from the different houses. “What makes them different is the methodologies used to calculate the index,” says Russell-Jones of FTSE. MSCI, for example, sets out to capture 60% of each country, he says, whereas FTSE aims to cover 85–90% of the market capitalisation of a country.
However, MSCI is in the process of increasing the coverage of indices within its Standard Index Series to 85%. This is part of its Enhanced Methodology changes which will be complete next summer.
Russell-Jones argues that there is still room in the marketplace for all the current index providers. “When you speak to anyone running a French fund, for example, whether he goes for large cap or small cap, he’s going to need a vast array of tools at his disposal.”
“I think all the index families have their own distinguishing characteristics,” says Michael Petronella, managing director of Dow Jones Indexes. He says it is the transparency and broad coverage of the Dow Jones indices which make them popular. “I think it comes down to index method and index replicability – which we define as transparency – and market coverage and market classification.”
Clients appreciate having the choice of index products offered by a number of providers, and would not appreciate having that choice narrowed by the demise of any of them, says Petronella.
What effect have the changes had to the equity markets themselves? The capitalisation of indices has changed, with index weights in some industrial sectors having altered significantly, says Fox.
“A lot of the older companies are having their weights changed quite radically, particularly in France, Germany and Italy, but not so much in Great Britain,” he says. Major cross-holdings and state-held stakes in companies are less prevalent in the UK than in these three continental European countries.
As a result of the spread of free float adjustments to indices, there will be quite a lot of investment money flowing out of France and Germany and into the UK and US and other markets that follow the Anglo-Saxon model, says Fox. “It’s going to be quite dramatic in terms of weights of passive portfolios,” he says.
It is not only trackers that will be affected by the index changes, he says. Large cap funds are effectively ‘closet trackers’, he says, because they have a fairly close resemblance to an index. These too will have to undergo significant rebalancing because of the changes in index weightings, says Fox.
Dow Jones’ Petronella acknowledges that market participants did have to rebalance their portfolios to reflect the new index weightings it introduced.
On 18 September last year, the Dow Jones Global Index family – including the Pan-European Dow Jones Stoxx indexes – and the Dow Jones US Total Market Index became weighted by free-float market capitalisation. Weightings in the Dow Jones Global Titans Index had already been changed to reflect free float on 18 June last year.
“Fund managers are always adjusting their portfolios, and this was just another reason,” he says.
MSCI was at pains to ease the effects of its transition on the markets, it says. “What we did when implementing float into the MSCI was to work hard to make sure the market changes were absolutely minimal,” says MSCI spokesman Evert-Jan ten Brundel.
The index provider introduced provisional indices in May, so that clients could see the new methodology in action before the actual migration. MSCI has begun the long-awaited process of altering weightings in its Standard Index Series to account for free float. The first phase of its implementation of its Enhanced Methodology took effect on 30 November. The second and final phase will take place at the end of May 2002.
As a result of the first phase of free-float adjustments to the MSCI Standard Index Series, the weight of developed markets in the MSCI ACWI (All Country World Index) Free Index rose to 96.2% from 95.3%.
And within the AWCI, the MSCI USA index’s weight rose to 53.4% from 50.7%, and the UK index rose to 10.3% from 9.9%. The greatest decreases in weight happened in the Japan, France and Germany indices.
MSCI is convinced its Enhanced Methodology has improved the product and its popularity. It is now a better platform for derivative products and exchange-traded funds, says ten Brundel. “We have taken on more business as a result,” he says.
Petronella of Dow Jones Indexes says the big question now is whether the market’s demand for all indices to be float weighted can be met. One of the US’s primary equity benchmarks, the S&P 500, still has not been altered, even though all of S&P’s other indices do take account of free-float.
Elliott Shurgin, vice president of index services at S&P’s, says it is estimated that if the S&P 500 were to be adjusted for free-float, some weightings would change by between 6% and 8%.
“There is a relatively small number of companies which would be affected, but of those, they would see significant weighting changes,” he says. Anyway, it is outside Europe – where cross-holdings are far more commonplace – that adjustments for free-float have the greatest effect, he says.