Adjusted free float

What Is Adjusted Free Float?

Adjusted free float refers to the portion of a company's shares outstanding that is readily available for trading in the public equity markets. This metric is a fundamental concept within Market Index Construction and is crucial for creating representative and investable stock market indices. Unlike a company's total market capitalization, which includes all issued shares, adjusted free float excludes shares that are not typically available for public trading. These often include shares held by strategic investors, such as company founders, governments, long-term institutional investors, or shares subject to lock-up periods. By accounting for these restricted holdings, the adjusted free float provides a more accurate reflection of a company's true liquidity and the supply of its shares actively traded in financial markets.²⁸

History and Origin

The concept of free float gained prominence in the late 20th and early 21st centuries as major index providers sought to enhance the accuracy and investability of their benchmarks. Initially, many prominent indices were based on full market capitalization, meaning all outstanding shares were included in a company's weighting, regardless of whether they were actively traded. However, this approach could lead to skewed index representation, as large blocks of illiquid shares held by insiders or governments might disproportionately influence an index's performance.

To address this, leading index providers such as MSCI, FTSE Russell, and S&P Dow Jones Indices began transitioning their methodologies to incorporate free float adjustments. MSCI, for instance, detailed its "Enhanced Methodology" to adjust the market capitalization of index constituents for free float, aiming to better reflect the proportion of shares available to international investors. This shift was implemented in phases, with the first phase taking effect in November 2001 and the second by May 2002.²⁶, ²⁷ FTSE Russell also adopted free float weighting in 2001, pioneering the application of free float to index constituents as early as 1984 with the Russell Indexes.²⁵ This evolution in methodology underscored the growing recognition of the importance of investability and actual market liquidity in index design, influencing portfolio management strategies globally.

Key Takeaways

• Adjusted free float represents the proportion of a company's shares available for public trading, excluding restricted or strategic holdings.
• It is a critical component in the calculation of market capitalization-weighted stock market indices, ensuring they accurately reflect investable supply.
• Major index providers adopted free-float methodologies to improve index representativeness, liquidity, and to reduce concentration risk.
• A higher adjusted free float generally correlates with increased liquidity and lower volatility for a stock.
• Understanding adjusted free float is essential for investors, especially those engaged in passive investing through index funds and exchange-traded funds (ETFs).

Formula and Calculation

The calculation of adjusted free float involves identifying and subtracting non-free float shares from a company's total shares outstanding. While the exact methodology can vary slightly among different index providers, the general concept remains consistent.

The most basic representation of free float shares can be expressed as:

Where:

• Total Shares Outstanding: The total number of a company's shares that have been authorized, issued, and are currently held by investors.
• Restricted Shares: Shares that are not available for public trading. These typically include:
  • Holdings by strategic investors (e.g., founders, controlling families, other corporations).
  • Shares held by governments or sovereign wealth funds.
  • Shares subject to lock-up periods (e.g., following an initial public offering (IPO)).
  • Cross-holdings (shares held by another company in the same group).
  • Shares held by employee stock ownership plans (ESOPs) that are not freely transferable.

Once the adjusted free float shares are determined, the free float market capitalization is calculated by multiplying these shares by the current market price per share:

This free float market capitalization is then used by index providers to determine the weight of a security within a market capitalization-weighted index.

Interpreting the Adjusted Free Float

The adjusted free float provides crucial insights into a company's tradability and its influence within stock market indices. A higher adjusted free float indicates that a larger proportion of a company's shares are available for public trading, contributing to greater liquidity. This means investors can more easily buy and sell the stock without significantly impacting its price, which is generally preferred by institutional investors.

Conversely, a lower adjusted free float suggests that a substantial portion of a company's shares is held by long-term, non-trading entities. This can lead to lower liquidity and potentially higher volatility, as fewer shares are available to absorb large buy or sell orders. Smaller free floats can also make a stock more susceptible to price manipulation or significant price swings based on relatively small trading volumes.²³, ²⁴ Index providers evaluate the adjusted free float to ensure that their indices accurately represent the investable universe of stocks, preventing an overweighting of companies with a large total market capitalization but limited tradable shares.

Hypothetical Example

Consider two hypothetical companies, Alpha Corp and Beta Inc., both with total shares outstanding of 100 million and a current share price of $50.

Alpha Corp:

• Shares held by founders and management: 30 million
• Shares held by a government entity: 10 million
• Shares under a lock-up agreement from a recent acquisition: 5 million

To calculate Alpha Corp's adjusted free float shares:
Adjusted Free Float Shares = 100 million - (30 million + 10 million + 5 million) = 100 million - 45 million = 55 million shares

Alpha Corp's Free Float Market Capitalization = 55 million shares * $50/share = $2.75 billion

Beta Inc.:

• Shares held by founders and management: 10 million
• Shares held by a passive long-term pension fund (classified as non-free float by index provider): 5 million

To calculate Beta Inc.'s adjusted free float shares:
Adjusted Free Float Shares = 100 million - (10 million + 5 million) = 100 million - 15 million = 85 million shares

Beta Inc.'s Free Float Market Capitalization = 85 million shares * $50/share = $4.25 billion

Even though both companies have the same total shares outstanding and share price, Beta Inc. has a significantly higher adjusted free float and thus a larger free float market capitalization. This implies Beta Inc.'s stock is more liquid and would likely receive a higher weighting in a free-float adjusted market index, making it more impactful for investment strategy that tracks such an index.

Practical Applications

Adjusted free float is a cornerstone in the world of financial markets, particularly in the construction and maintenance of equity indices. Its primary applications include:

• Index Construction and Weighting: Major stock market indices globally, such as the S&P 500, MSCI World Index, FTSE 100, Nifty 50, and CAC 40, utilize free-float methodologies.²¹, ²² This ensures that the weight of each company in an index accurately reflects the proportion of its shares available for public trading, rather than its total market value, which might include illiquid strategic holdings. This approach aims to make indices more representative of the actual tradable market.²⁰
• Passive Investing and ETFs: For passive investing vehicles like index funds and exchange-traded funds (ETFs), the adjusted free float is critical. These funds aim to replicate the performance of a specific index, and by tracking a free-float adjusted index, they ensure that their portfolio allocations are aligned with the readily available and liquid shares in the market. This minimizes tracking error and ensures that the fund's holdings accurately reflect what can be bought and sold by investors.¹⁸, ¹⁹
• Liquidity Assessment: Adjusted free float serves as a key indicator of a stock's liquidity. Companies with a higher adjusted free float typically exhibit greater trading activity and tighter bid-ask spreads, making it easier for investors to enter and exit positions without causing significant price dislocations.¹⁷ This is particularly important for large institutional investors who need to trade substantial volumes.
• Market Transparency and Fairness: By excluding shares held by insiders or restricted parties, adjusted free float methodologies promote greater market transparency and fairness. They reduce the potential for large, untradable blocks of shares to distort index performance or create artificial market concentrations. The FTSE Russell, for example, continuously consults on and enhances its free float restrictions methodology to improve transparency and precision in its calculations.¹⁵, ¹⁶

Limitations and Criticisms

Despite its widespread adoption, the concept of adjusted free float is not without its limitations and criticisms. One significant challenge lies in the subjectivity of classification. Index providers must make determinations about which shareholdings constitute "restricted" or "strategic" and are therefore excluded from the free float. While general guidelines exist, such as excluding government holdings or shares under lock-up periods, the specific thresholds and interpretations can vary, potentially leading to discrepancies in a company's free float calculation across different indices. For example, some index providers may have specific rules regarding holdings by founders, private equity firms, or individuals, often involving percentage thresholds.¹³, ¹⁴

Another criticism revolves around data accuracy and timeliness. The precise ownership data required to calculate adjusted free float can be complex to obtain and keep current, especially for companies with diverse shareholder bases across multiple stock exchanges. Any inaccuracies or delays in this data can impact the calculated free float and, consequently, a company's weighting in an index. Furthermore, while a higher free float is generally associated with lower volatility, some academic research suggests a more nuanced relationship, with one study on the Istanbul Stock Exchange finding that while higher free float correlated with higher trading activity, it could also be associated with increased price volatility.¹¹, ¹²

Finally, the focus on adjusted free float in index construction has implications for diversification and market concentration. While it aims to prevent illiquid shares from distorting index weights, some critics argue that heavily relying on free-float adjusted market capitalization in broad market indices can still lead to significant concentration in a few large, highly liquid companies. This can expose passive investors to elevated risks if those concentrated holdings underperform.¹⁰

Adjusted Free Float vs. Full Market Capitalization

The primary distinction between adjusted free float and market capitalization (often referred to as full market capitalization) lies in the shares included in the calculation. Full market capitalization represents the total value of all of a company's outstanding shares, irrespective of who holds them or whether they are available for public trading. It is simply calculated as the total number of shares outstanding multiplied by the current share price.

In contrast, adjusted free float (specifically, free float market capitalization) measures the market value of only those shares that are readily available for trading by the public. It intentionally excludes shares held by insiders, governments, strategic long-term investors, or those subject to trading restrictions like lock-up periods. The confusion often arises because "market capitalization" is sometimes used loosely to refer to both concepts. However, for the purpose of index construction and reflecting actual market liquidity, adjusted free float provides a more precise and investable figure. Index providers widely prefer the adjusted free float methodology as it offers a more accurate representation of the supply and demand dynamics in the public market.⁹

FAQs

Q1: Why do index providers use adjusted free float?
A1: Index providers use adjusted free float to ensure that their indices accurately reflect the investable portion of the market. This helps to prevent illiquid shares, such as those held by company insiders or governments, from disproportionately influencing an index's performance and making it difficult for passive investing vehicles like ETFs to track accurately.⁷, ⁸

Q2: What types of shares are typically excluded from adjusted free float?
A2: Shares typically excluded from the adjusted free float calculation include those held by company founders, management, governments, sovereign wealth funds, long-term strategic investors, and shares that are under contractual lock-up periods following an IPO or other corporate actions.⁵, ⁶

Q3: How does adjusted free float impact a stock's liquidity?
A3: A higher adjusted free float generally indicates greater liquidity for a stock. With more shares available for public trading, it becomes easier for buyers and sellers to find counterparts, leading to tighter bid-ask spreads and less price impact from large trades.⁴

Q4: Can a company's adjusted free float change over time?
A4: Yes, a company's adjusted free float can change due to various corporate actions like new share issuances, share buybacks, changes in insider holdings, or the expiry of lock-up periods. Index providers regularly review and adjust free float figures to maintain index accuracy.¹, ², ³

Q5: Is adjusted free float relevant for individual investors?
A5: While individual investors may not calculate adjusted free float directly, understanding the concept is important. It helps in recognizing why certain stocks have higher trading volumes or less volatility, and it explains how market indices, which many individual investors track through funds, are constructed and weighted.