Understanding 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 the Index. Free-float market capitalization takes into consideration only those 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.
Subsequently all BSE indices with the exception of BSE PSU index have adopted the free-float methodology.
Major Advantages of Free-float Methodology
Definition of Free-float
- 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.
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 investible 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.
Shareholdings of investors that would not, in the normal course, come into the open market for trading are treated as 'Controlling/ Strategic Holdings' and hence not included in free-float. Specifically, the following categories of holding are generally excluded from the definition of Free-float:
The remaining shareholders fall under the Free-float category.
Determining Free-float Factors of Companies
- Shares held by founders/directors/acquirers which has control element
- Shares held by persons/ bodies with "Controlling Interest"
- Shares held by Government as promoter/acquirer
- Holdings through the FDI Route
- Strategic stakes by private corporate bodies/ individuals
- Equity held by associate/group companies (cross-holdings)
- Equity held by Employee Welfare Trusts
- Locked-in shares and shares which would not be sold in the open market in normal course.
BSE has designed a Free-float format, which is filled and submitted by all index companies on a quarterly basis (Format available on www.bseindia.com
). BSE determines the Free-float factor for each company based on the detailed information submitted by the companies in the prescribed format. Free-float factor is a multiple with which the total market capitalization of a company is adjusted to arrive at the Free-float market capitalization. Once the Free-float of a company is determined, it is rounded-off to the higher multiple of 5 and each company is categorized into one of the 20 bands given below. A Free-float factor of say 0.55 means that only 55% of the market capitalization of the company will be considered for index calculation.
|>0 – 5%
||>50 – 55%
|>5 – 10%
||>55 – 60%
|>10 – 15%
||>60 – 65%
|>15 – 20%
||>65 – 70%
|>20 – 25%
||>70 – 75%
|>25 – 30%
||>75 – 80%
|>30 – 35%
||>80 – 85%
|>35 – 40%
||>85 – 90%
|>40 – 45%
||>90 – 95%
|>45 – 50%
||>95 – 100%