|The Philosophy and Practical Aspects of Float Adjustment for the S&P 500
By David M. Blitzer
Managing Director & Chairman of the Index Committee
Standard & Poor's
Float and float adjustment are not new to the S&P 500 and our other indices. Because S&P’s indices, especially the S&P 500, are tradable, investable and liquid, float has been a concern for a long time.
Discussions since our March 2004 announcement of the move to full float adjustment have been fascinating – we have spent a lot of time talking to both index users and companies in the index. We have a much better understanding of both groups’ concerns about float. We also understand some of the conceptions – and misconceptions –in the market. In this essay, I will go over some of these and explain how this latest evolution in the S&P 500 and our other U.S. indices is proceeding.
The other aspect of the float discussions is that they have been fairly public. I have a large stack of research reports – some probably written by people in this room – explaining what S&P is doing. The size of the stack is attributable to the $1 trillion tracking the S&P 500 index; the interest by companies in the indices is due to the 10% of each company in the 500 held by index funds as a group. No wonder the index attracts attention. That trillion dollars also explains why stocks sometimes move when they are added to the index. More importantly, it explains why companies in the 500, or our other indices, often want to speak with us. We do meet with companies. However, we only deal in public information and we remind companies that we can’t tell them about our decisions in advance of a general announcement for all investors – index changes are publicly announced to preserve a level playing field.
Float and Standard & Poor’s
Float and recognizing the importance of float in indices is not new to S&P. For as far back as I can discover, S&P has required that companies in the S&P 500 or our other U.S. indices have public float of at least 50% of their outstanding stock. I am not sure if this goes back to 1923 when the indices began or 1957 when the 500 became 500 stocks, but it certainly began a long time ago.
The rationale is simple – if public float is less than 50%, liquidity may be affected and investors’ ability to buy stock or possibly control is limited. The 50% rule is a simple and effective form of float adjustment. First, it works; second, it didn’t require a lot of maintenance and research; and, third, it was easy for investors to understand or verify.
The change announced in March 2004 are not introducing float adjustment. Rather, it is moving the S&P 500 from the 50% rule to full float adjustment. These changes will accomplish four things:
- we will produce and publish some interesting and useful investment data
- We will please some commentators and analysts who argued that the world had moved beyond a simple 50% rule to full float adjustment, and
- We will eliminate a “red herring” kind of complaint from some of our competitors.
- Most of all, this is another evolutionary change in the S&P 500 and the other indices – one more of many improvements.
One thing that will not change is the liquidity and performance of the S&P 500 – our research shows that the tracking error between the float and non-float versions of the S&P 500 is about 30 basis points. The average float factor is 95% and almost 80% of the stocks have a float factor of 1.0. The figures are similar for the S&P MidCap 400 and S&P Smallcap 600.
Liquidity is the real goal of any float adjustment effort. However, it takes more than some float measures to assure liquidity. The keys to a liquid and tradable index are both stock selection and attracting a lot of money to the underlying cash index. If there aren’t any investors, there probably won’t be much liquidity or much support for derivatives and such things. It is the trillion dollars invested in the S&P 500 that makes it all work. That trillion dollars is built on two things: fairness and performance.
By fairness, I mean that an investor can buy the 500 stocks in the same proportions as the index and get the same results. It works – look at the performance data reported by fund managers such as State Street, Northern Trust, Vanguard, BGI and others. This is important since the fairness not only supports indexers, but also benchmark users who welcome an honest yardstick.
There is not much that needs to be said about performance for this conference – indices tend to outperform about two-thirds of the active managers. This is due to both lower costs and lower turnover for the indices than active managers. Of course, since it is difficult to guess which active manager will be in the lucky one-third that outperforms next year, practically speaking, indexes are the better bet.
Fairness and performance contribute to the invested base of the index which is a key to its liquidity. These factors also create a natural pool of investors interested in hedging their positions and controlling their risks – an attractive audience for derivatives writers and others.
Moving to full float adjustment marginally raises the S&P 500’s liquidity. However, that liquidity was not in danger before because we have consistently tested stocks selected for the indices for liquidity. The rule – annual share turnover must be at least 30% – has been around for at least two decades and is carefully followed. We also look at other measures include the number of shares outstanding, the price range and dollar value traded. Through all this, we haven’t found better measures and continue to make turnover the lead factor for liquidity.
One other aspect that matters is that we monitor liquidity, especially when stocks get into difficulty. If a stock slides to low levels, say a few dollars a share, we will watch it carefully. If liquidity begins to dry up and the only time volume appears is on the down-side, we will consider removing the stock before it becomes a major problem for index funds to trade. These lessons – which we compiled in research a couple of years ago have stood us in good stead in both the U.S. and around the world. And, I should add, one of the key steps we took in developing indices outside the U.S. in the last ten years was to consider liquidity.
Another key attribute of indices is transparency, and here again we are learning new things as we go through the detailed work on float adjustment. For investors, transparency means two things. First, the index provider – S&P – should publish index guidelines and criteria. Second, it helps if a lot of other people – analysts, journalist and other index users, also publish a lot of commentary so there are a range of opinions and analyses available to investors. With the S&P 500 and our U.S. indices, investors can benefit from this plurality of voices. In fact, one frustrating issue we face at S&P is that we rarely account for more than 5% of what is written on the S&P 500.
Let me turn to what we’ve done with float. Early on we established a philosophical definition of float. An investor is one who sees his position as an investment and decides to buy or sell based on his estimates of the company’s earnings, stock price, probable future returns and other developments. However, if he judges his investment because it helps give him control of a company or fulfills a family or political commitment or tracks some other non-monetary and non-investment goal, he is not an investor and, if large enough, is a strategic holder. Members of a Board of Directors who pledge not to sell their stock are strategic-holders. So are members of the founding family or another corporation. Once we knew what we were looking for, we were able to go look for it.
Two companies - UPS and MetLife - seem to have been picked by numerous analysts as two of the hardest hit by float-adjustment. But in reality, this is not so. UPS has an unusually large number of employee-shareholders, a heritage of its private company days. Leave aside the senior executives and the board of directors and consider the majority of employees. For them to sell their stock all that is needed is a call to their broker and a second call to their human resources department to transfer shares from one class to another. Given our approach as I just described, the employee shares are included in float. MetLife is a similar story, though with a different beginning. When MetLife demutualized it distributed shares to its policy holders. Given the large number of small shareholders, many of whom did not have any other common stocks in their portfolios, MetLife set up a trust to reduce paperwork costs and make trading simpler for these small shareholders. Here again the trust does not limit anyone’s ability to trade stocks, so the shares in the trust are in the float.
These examples do more than correct the data on two large companies. More importantly, they show that transparency is not simply some publications or a nice web site. Transparency means providing a lot of background and explanation, talking to index users, listening to investors and companies in the index and working to keep everyone informed. S&P is committed to true transparency. Meetings and discussions we have held, and will continue to hold about float and other issues are part of this process.
In doing the float analysis, we have divided holders into three groups:
- Corporate holdings – publicly traded companies, venture capital firms, private equity or LBO firms,
- Government holdings,
- Holdings by officers, directors, founders, family members, family trusts and so forth.
If the holdings in any one of these groups exceeds 10%, the holdings are excluded from float shares. There is nothing magical about 10%, but based on the data it is a reasonable figures. In the U.S., data is rarely available below the 5% level. The calculations are done to the nearest one percent which may exceed the accuracy of some of the data. There are no bands or barriers.
One important aspect of our approach of trying to separate strategic holders from investors is that mutual funds are investors and are not excluded from float shares. True a money manager may have position in a company that doesn’t change from year to year, but that is still an investment not a strategic holding. In fact, if the money manager is running an index fund, he is doing exactly what he should be doing.
Before getting into a few numbers, there is one other important item that I want to focus on. Over the last year or two, I have heard a lot of comments about float and the need for S&P to adopt float and move into the modern era. As I’ve explained, we have always required that the goal of float – liquidity – be a principal attribute of our indices. In fact, in terms of liquid tradable indices, S&P is be the leader. One reason why we lead the way with investable indices is that we believe in index investing. Yes, S&P has a large staff of equity analysts making stock recommendations and S&P is the leading provider of independent equity research. Very importantly for indexes – and S&P is a strong believer in index-based investing – the S&P 500 is the basis of the first and largest retail index fund, the first and largest ETF and the largest institutional funds as well as the first successful index futures, of VIX and many other innovations.
As to float, all we have done is take an opportunity to continue the evolution of our indices so that they will continue to be fair, investable and liquid measures of the market. In no way were any of our indices out of touch or behind the times.
Some Preliminary Numbers
S&P has published an analysis of the shift to float – available in the exhibits area – which provides a lot of data. There are a few items I would to high-light here for the S&P 500. The analysis covers the S&P MidCap 400 and S&P Smallcap 600 as well.
- Turnover due to the shift to float is expected to be 3.34%. By comparison, average turnover for 2001 to 2003 was 3.23%. This is essentially what we estimated in March.
- Tracking error between the float and non-float indices is 31 bp
- Of the 500 companies, 395 have factors of 1.0. The average factor is about 0.95.
- Most affected, ranked by their change in index weight in percentage points are Wal-Mart, -0.79; Microsoft, -0.33; Goldman Sachs, -0.15; Oracle, -0.14; Nike, -0.10 and E-Bay, -0.10. Everyone else is less than 0.10 weight change,
- General Electric and ExxonMobil are the biggest gainers at 0.14 and 0.12.
Research available from the marketplace (buy-side and sell-side) will update these figures, and some will be available on this “E-ppendix” or on the affiliated IndexUniverse.com site. In the meantime, we are confident that the transparency of our float-adjustment process will result in a smooth transition to a better S&P 500 index.
 For complete details see documents available on http://www.freefloat.standardandpoors.com/.