Adjusted free index

What Is an Adjusted Free Index?

An Adjusted Free Index is a type of stock market index whose constituents are weighted based on their free float-adjusted market capitalization. This approach in index construction seeks to reflect the true investable opportunity set in equity markets by considering only the shares of a company that are readily available for public trading, excluding those held by insiders, governments, strategic holders, or other entities with restricted trading access. The aim is to create a more realistic benchmark for investors, particularly for index funds and exchange-traded funds that aim to replicate market performance. This methodology ensures that the index’s representation aligns closely with the shares that can actually be bought and sold by the typical institutional investors and retail participants, thereby enhancing its utility as an investment vehicle.

History and Origin

The concept of adjusting indices for free float gained significant traction among major global index providers in the early 21st century. Historically, many indices were weighted simply by a company's total market capitalization (outstanding shares multiplied by price), without distinguishing between shares that were freely traded and those that were closely held. However, as global equity markets became more interconnected and the influence of passive investing grew, the need for more investable and replicable benchmarks became apparent.

Pioneering index providers like MSCI (formerly Morgan Stanley Capital International) played a crucial role in standardizing this approach. MSCI introduced its Global Investable Market Indexes (GIMI) methodology, which incorporated free float adjustments, completing its transition by the end of May 2008. S⁷imilarly, S&P Dow Jones Indices adopted a float-adjusted methodology for many of its equity indices, including the widely followed S&P 500, recognizing the importance of reflecting the actual tradable universe. T⁶his shift was driven by a collective recognition within the financial industry that an index should represent what is genuinely available for investment, thereby providing a more accurate measure of market performance and facilitating more efficient portfolio diversification.

Key Takeaways

• An Adjusted Free Index weights its constituents based on the portion of shares available for public trading (free float).
• This methodology aims to provide a more accurate representation of the investable market opportunity.
• It is widely adopted by major index providers like MSCI and S&P Dow Jones Indices for their global benchmarks.
• Adjusted Free Indices enhance the replicability of index funds and exchange-traded funds.
• The approach supports improved risk management and asset allocation decisions for investors.

Formula and Calculation

The calculation of an Adjusted Free Index typically involves determining the free float-adjusted market capitalization for each constituent company. This is distinct from a company's total market capitalization. The fundamental formula for an index, generally a market capitalization-weighted index (which an Adjusted Free Index is, but with an adjustment), involves a divisor that maintains continuity as index components change.

The free float-adjusted market capitalization ((FMC)) for a single company is calculated as:

[FMC = P \times S_F]

Where:

• (P) = Current stock price
• (S_F) = Number of free float shares (shares available for public trading)

The index value itself for a market capitalization-weighted index, adjusted for free float, can be expressed as:

[Index Value = \frac{\sum (P_i \times S_{Fi})}{Divisor}]

Where:

• (P_i) = Price of security (i)
• (S_{Fi}) = Free float shares of security (i)
• (Divisor) = A proprietary number adjusted for corporate actions (e.g., stock splits, mergers, or changes in shares outstanding) to ensure index continuity and prevent artificial jumps or drops in the index value.

⁵The summation (\sum (P_i \times S_{Fi})) represents the aggregate free float-adjusted market capitalization of all securities within the index.

Interpreting the Adjusted Free Index

An Adjusted Free Index provides a clearer picture of the actual tradable market. When analyzing an Adjusted Free Index, a higher value generally signifies an increase in the aggregate market capitalization of the freely tradable shares of the constituent companies, reflecting overall market growth. Conversely, a decline indicates a contraction.

For investors, interpreting an Adjusted Free Index involves understanding that the performance tracked is genuinely reflective of what is achievable through public markets. This is particularly relevant for passive investment vehicles that aim to mirror an index. The total return of such an index (which includes price changes and dividends) offers a reliable benchmark against which actively managed portfolios can be evaluated. The underlying liquidity of the index constituents, as factored by the free float, also provides insights into how easily a large position in the index's underlying securities could be traded without significantly impacting their prices.

Hypothetical Example

Consider a hypothetical "Diversification Global Tech Index," which is an Adjusted Free Index. Let's say it includes two companies: Alpha Corp and Beta Inc.

• Alpha Corp:

  • Total Shares Outstanding: 1,000,000
  • Shares held by founders (restricted): 300,000
  • Current Stock Price: $100
  • Free float shares = 1,000,000 - 300,000 = 700,000
  • Free Float-Adjusted Market Capitalization for Alpha Corp = 700,000 shares * $100/share = $70,000,000

• Beta Inc:

  • Total Shares Outstanding: 500,000
  • Shares held by a government entity (restricted): 100,000
  • Current Stock Price: $200
  • Free float shares = 500,000 - 100,000 = 400,000
  • Free Float-Adjusted Market Capitalization for Beta Inc = 400,000 shares * $200/share = $80,000,000

If the Divisor for the Diversification Global Tech Index is, for example, 1,000,000:

Total Free Float-Adjusted Market Capitalization = $70,000,000 (Alpha) + $80,000,000 (Beta) = $150,000,000

Index Value = $150,000,000 / 1,000,000 = 150.

This calculation demonstrates how only the investable share classes contribute to the index weighting, ensuring the index reflects the true market accessible to investors.

Practical Applications

Adjusted Free Indices are fundamental tools in modern finance, used extensively in various practical applications:

• Passive Investment Products: The most direct application is in the creation and management of index funds and exchange-traded funds (ETFs). These investment vehicles are designed to replicate the performance of a specific stock market index, and using an Adjusted Free Index ensures that the fund can realistically acquire and hold the underlying securities in proportion to their actual market availability. This helps minimize tracking error.
  *⁴ Performance Benchmarking: Asset managers and institutional investors commonly use Adjusted Free Indices as a benchmark to evaluate the performance of their portfolios or specific investment strategies. By comparing returns against a free float-adjusted index, they can assess their ability to generate alpha relative to the investable market.
• Global Market Access: For international equity markets, particularly emerging and frontier markets where foreign ownership restrictions or significant strategic holdings are common, free float adjustments are critical. For instance, MSCI's decision to include China A-shares in its Emerging Markets Index involved careful consideration of market accessibility and available free float, enabling greater foreign institutional investors participation.
  *³ Asset Allocation Decisions: Portfolio managers rely on these indices for informed asset allocation. By understanding the true size and composition of freely tradable segments of the market, they can make more accurate decisions about allocating capital across different regions, sectors, and market capitalization sizes.
• Risk Management: The free float adjustment contributes to better risk management by presenting a more accurate picture of a market's liquidity and true tradable size, which is vital for managing portfolio exposure and potential trading impacts.

Limitations and Criticisms

While the Adjusted Free Index methodology offers significant advantages in representing the investable universe, it is not without limitations or criticisms:

• Complexity and Data Dependency: The accurate calculation of free float requires detailed and continuously updated data on share ownership, which can be challenging to obtain and verify, especially in less transparent markets. Index providers must constantly monitor changes in ownership structures, such as lock-up agreements or strategic investments, to ensure the index accurately reflects the available float.
• Arbitrary Free Float Factors: The "free float" percentage for a company is often determined by the index provider based on various criteria, which can sometimes involve a degree of subjective judgment. Different index providers might assign slightly different free float factors to the same company, leading to variations in index composition and weighting.
• Impact on Corporate Governance: Some critics argue that the rise of large index funds, which primarily track free float-adjusted market capitalization-weighted indices, can lead to a concentration of ownership among a few passive managers. This concentration might reduce active oversight of corporate management, as index funds have limited ability to sell out of underperforming companies. T²his shift could potentially lead to what some researchers describe as "passive compliance" from companies, affecting aspects like financial reporting quality.
  *¹ Market Concentration: In highly concentrated markets, where a few large companies dominate the free float, an Adjusted Free Index can still lead to significant concentration in the index itself, making it heavily reliant on the performance of a few large companies. This can increase portfolio volatility for those tracking the index.

Adjusted Free Index vs. Market Capitalization Weighted Index

The primary distinction between an Adjusted Free Index and a pure Market Capitalization Weighted Index lies in how the weight of each constituent company is determined.

A Market Capitalization Weighted Index (also known as a full market capitalization-weighted index) assigns weights to companies strictly based on their total outstanding market capitalization. This means that every share issued by a company, regardless of whether it is freely tradable on the public market or held by insiders, governments, or strategic investors, contributes to its weight in the index.

In contrast, an Adjusted Free Index specifically adjusts for this by considering only the "free float"—the portion of shares available for public purchase and sale. This adjustment is crucial because a company's total market capitalization might be significantly larger than its genuinely investable portion if a large percentage of its shares are locked up or held by entities unlikely to trade them. Therefore, an Adjusted Free Index aims to provide a more accurate and practical benchmark for investors seeking to replicate the market's performance, as it reflects the true supply and demand dynamics of tradable shares. The former offers a theoretical total market value, while the latter represents the effective market available to the general investing public.

FAQs

Why is free float adjustment important for indices?

Free float adjustment is important because it ensures that an index accurately represents the shares that are actually available for trading in the public equity markets. This makes the index more investable and replicable, especially for large index funds and exchange-traded funds that aim to track its performance.

How does an Adjusted Free Index benefit passive investors?

For passive investors, an Adjusted Free Index provides a more realistic benchmark for their investment vehicles. By tracking an index that excludes illiquid or restricted shares, passive funds can minimize "tracking error," which is the difference between the fund's performance and the index's performance. This supports efficient asset allocation.

Do all major indices use free float adjustment?

Many prominent global indices, such as those provided by MSCI and S&P Dow Jones Indices, largely incorporate free float adjustment in their methodologies. However, some older or specialized indices might still use a full market capitalization weighting or other weighting schemes, so it's essential to check the specific methodology of any stock market index.

What types of shares are typically excluded from free float?

Shares typically excluded from free float calculations include those held by strategic investors (e.g., other corporations), governments, company founders, board members, employees (if subject to long-term lock-ups), or those held in treasury. The aim is to remove shares that are not readily available to public investors or are subject to trading restrictions.

How does free float relate to market liquidity?

Free float is directly related to liquidity because it quantifies the portion of a company's shares that are actively traded. A higher free float generally implies greater liquidity, as more shares are available for buying and selling, which can reduce price volatility and make it easier for investors to enter or exit positions without significant market impact.