Adjusted free price index

What Is Adjusted Free Price Index?

The term "Adjusted Free Price Index" refers to a type of stock market index where the component stocks are weighted based on their "free-float adjusted market capitalization" and the index itself tracks only price movements, excluding dividends. This methodology falls under the broader category of indexology, which involves the construction and maintenance of financial benchmarks. The "free-float adjustment" ensures that the index reflects only those shares readily available for public trading, offering a more accurate representation of the investable universe within a given market. Consequently, an Adjusted Free Price Index is designed to provide a truer measure of market sentiment and the performance of actively traded equity securities.

History and Origin

The concept of free-float adjustment in indices gained significant traction in the early 2000s, driven by a desire for more investable and accurate benchmarks. Historically, many market capitalization-weighted indices included all outstanding shares of a company, regardless of whether they were available for public trading. However, shares held by strategic investors, such as governments, corporate insiders, or cross-holdings, are typically not traded frequently and thus do not reflect the true market supply and demand.

Major index providers began to transition their flagship indices to a free-float adjusted methodology to address this. MSCI (Morgan Stanley Capital International) implemented a phased approach to recalibrate its global equity indices for free float, starting in November 2001 and completing by May 2002²⁹, ³⁰. This move, which aimed to reflect the portion of shares actually available to the market, was expected to have a significant impact on investors adjusting their portfolios²⁸. Similarly, S&P Dow Jones Indices announced its shift to "float-adjusted market capitalization weights" for its U.S. indices, including the S&P 500, with a transition period from September 2004 to September 2005²⁷. This widespread adoption by leading index providers underscored the industry's recognition of free-float methodology as a superior way to construct relevant benchmarks for passive investing strategies.

Key Takeaways

• An Adjusted Free Price Index weights companies based on shares available for public trading, excluding restricted holdings.
• It tracks only price movements, not including dividend reinvestment.
• The methodology aims to provide a more accurate reflection of the readily tradable market value of companies.
• It influences the composition and performance of major global benchmarks and investment products like Exchange-Traded Funds.
• Free-float adjustment enhances liquidity and reduces the concentration of highly illiquid shares within an index.

Formula and Calculation

The calculation of an Adjusted Free Price Index involves several steps, primarily focusing on determining the free-float market capitalization for each constituent and then aggregating these values. The general formula for the free-float market capitalization of a single company is:

The "Number of Free-Float Shares" is derived from the total shares outstanding minus shares deemed "non-free float." These non-free float shares typically include:

• Shares held by strategic investors (e.g., founders, family trusts, governments, other publicly traded companies)²⁵, ²⁶.
• Locked-in shares, such as those subject to lock-up periods following an Initial Public Offering (IPO) or held by insiders.
• Shares subject to foreign ownership limits (FOL), where only a certain proportion is available to international investors²⁴.

For the overall Adjusted Free Price Index, the calculation is often divisor-based, similar to many other market capitalization-weighted indices. The index value is typically derived as:

Where:

• (\text{Share Price}_i) is the current price of stock (i).
• (\text{Free-Float Shares}_i) is the number of free-float shares for stock (i).
• The sum (\sum) is across all stocks in the index.
• The Divisor is a value adjusted for corporate actions and changes in index composition to ensure continuity of the index level²³.

Index providers like MSCI and S&P Dow Jones Indices have detailed methodologies for identifying and classifying non-free float shareholdings²¹, ²². These methodologies involve categorizing investor types into strategic and non-strategic and may also consider foreign ownership limits²⁰.

Interpreting the Adjusted Free Price Index

An Adjusted Free Price Index provides investors and analysts with a clearer view of the readily tradable portion of the market. Its interpretation revolves around understanding that the index's movements primarily reflect the supply and demand dynamics of shares that are genuinely available for buying and selling.

When the value of an Adjusted Free Price Index rises, it indicates that the collective price of its free-float adjusted constituent stocks has increased. Conversely, a decline suggests a decrease in these prices. Because this index only considers price movements, it may not fully capture the total return for an investor, as dividends are excluded. Therefore, investors often look at both price indices and total return indices for a complete picture of investment performance.

The weighting based on free-float market capitalization means that companies with a higher proportion of their shares publicly traded will have a greater influence on the index's performance. This focus on liquidity means the index is generally considered more representative of actual market movements experienced by the majority of investors. It helps in evaluating the true benchmark against which active fund managers or individual portfolios are measured.

Hypothetical Example

Consider a hypothetical market consisting of three companies: Alpha Co., Beta Corp., and Gamma Inc.

• Alpha Co.:
  • Total Shares Outstanding: 10,000,000
  • Shares held by founder (restricted): 3,000,000
  • Current Share Price: $50
• Beta Corp.:
  • Total Shares Outstanding: 8,000,000
  • Shares held by government (restricted): 4,000,000
  • Current Share Price: $75
• Gamma Inc.:
  • Total Shares Outstanding: 12,000,000
  • Shares held by institutional investor (long-term, strategic): 2,000,000
  • Current Share Price: $25

To calculate the Adjusted Free Price Index for this market, we first determine the free-float shares for each company:

• Alpha Co.: (10,000,000 - 3,000,000 = 7,000,000) free-float shares
• Beta Corp.: (8,000,000 - 4,000,000 = 4,000,000) free-float shares
• Gamma Inc.: (12,000,000 - 2,000,000 = 10,000,000) free-float shares

Next, calculate the free-float market capitalization for each:

• Alpha Co.: (7,000,000 \text{ shares} \times $50/\text{share} = $350,000,000)
• Beta Corp.: (4,000,000 \text{ shares} \times $75/\text{share} = $300,000,000)
• Gamma Inc.: (10,000,000 \text{ shares} \times $25/\text{share} = $250,000,000)

The sum of free-float market capitalizations for these three companies is:
($350,000,000 + $300,000,000 + $250,000,000 = $900,000,000)

If the initial divisor for this index was, for example, 450,000, the index value would be:
($900,000,000 / 450,000 = 2,000)

This example illustrates how the "Adjusted Free Price Index" reflects only the segment of shares genuinely available to the public, influencing its overall value and responsiveness to market activity. Understanding these calculations is key to proper portfolio management.

Practical Applications

The Adjusted Free Price Index, or more broadly, indices using a free-float adjustment, serve several crucial functions in finance:

• Investment Benchmarking: They are widely used as benchmark indices for passive investment products such as Exchange-Traded Funds (ETFs) and mutual funds that aim to replicate market performance. By tracking only publicly available shares, these indices provide a more realistic target for portfolio replication¹⁹.
• Performance Measurement: Investors and fund managers rely on these indices to accurately assess the performance of their equity portfolios against the investable market. The free-float adjustment helps prevent skewed representation by companies with large, but illiquid, strategic holdings.
• Market Analysis and Research: Financial analysis benefits from indices that reflect actual market dynamics. Researchers use free-float adjusted data to study market efficiency, liquidity, and the behavior of stock prices, as the data more accurately represents the supply and demand for shares¹⁸.
• Capital Allocation: Index providers publish their free-float methodologies, which guides institutional investors and global asset managers in their capital allocation decisions, particularly in emerging markets where foreign ownership limits might impact the free-float of certain stocks¹⁷.
• Transparency and Investability: By focusing on readily tradable shares, free-float adjusted indices enhance transparency and improve the investability of the index for a broad range of market participants. This is critical for large-scale investment strategies. For example, MSCI's adoption of the free-float methodology helped increase the coverage of its Standard Index series to 85% of free-float adjusted market capitalization, providing greater diversification and representation of market opportunities¹⁶.

Limitations and Criticisms

While widely adopted, the Adjusted Free Price Index methodology and free-float adjustment in general are not without limitations and criticisms.

One primary criticism centers on the potential for "index-linked investing" to distort stock prices and risk-return tradeoffs. When a stock is added to a major free-float adjusted index, index funds that track that benchmark must buy the stock, potentially causing a temporary price increase unrelated to fundamental value¹⁴, ¹⁵. Conversely, deletions can lead to selling pressure. This mechanical buying and selling, driven by index inclusion or exclusion rather than fundamental analysis, can influence market dynamics and raise questions about efficient price discovery¹³. Research suggests these effects can intensify as index-linked investing grows¹².

Another limitation lies in the subjective nature of determining "free float." Different index providers may have slightly varying criteria for classifying restricted shares, leading to discrepancies in free-float factors and, consequently, in index composition and weights¹¹. This lack of universal standardization can complicate cross-index comparisons.

Furthermore, while free-float adjustment aims to enhance liquidity, it doesn't eliminate volatility. In fact, some studies suggest that while higher free-float generally correlates with lower price volatility due to increased liquidity, there can be complex relationships depending on market conditions and specific company characteristics¹⁰.

Lastly, focusing solely on a "price index" means that dividend income, a significant component of total investment return, is excluded. This can misrepresent the full financial benefit to long-term investors, as total return indices, which account for dividend reinvestment, often show different performance trajectories over time. For instance, an increase in a company's free float can lead to more favorable stock characteristics such as improved liquidity and lower volatility, and historically, investors have responded positively to companies that increased their free float, leading to a positive price impact⁹. However, the economic impact of these adjustments on the broader market is a subject of ongoing academic inquiry⁷, ⁸.

Adjusted Free Price Index vs. Full Market Capitalization

The key distinction between an Adjusted Free Price Index and an index based on full market capitalization lies in how they account for a company's outstanding shares.

Confusion often arises because both methodologies involve "market capitalization." However, the Adjusted Free Price Index (or any free-float adjusted index) provides a more practical and realistic measure for financial professionals and individual investors. It reflects what is genuinely available for trade, offering a better gauge of where capital can be deployed and how liquid a market truly is⁵. The shift to free-float adjustment by major index providers globally highlights its perceived superiority in representing active market movements.

FAQs

What does "free-float adjusted" mean in an index?

"Free-float adjusted" means that the index only considers the portion of a company's shares that are available for trading in the public market. It excludes shares held by long-term strategic holders such as governments, corporate insiders, or other companies that are not likely to be traded³, ⁴. This adjustment aims to make the index a more accurate reflection of the investable market.

Why is the Adjusted Free Price Index important for investors?

This index is crucial because it provides a more realistic benchmark for investment performance. It helps investors understand the actual market value of shares they can buy and sell, influencing portfolio construction for products like Exchange-Traded Funds and mutual funds. It also gives a better sense of market liquidity and potential volatility of index components.

How does an Adjusted Free Price Index differ from a Total Return Index?

An Adjusted Free Price Index tracks only the price movements of its constituent stocks, meaning it does not account for dividends paid out by the companies. A Total Return Index, on the other hand, factors in both price changes and the reinvestment of dividends, providing a more comprehensive measure of an investment's overall return. For most long-term investors, a Total Return Index is a more appropriate measure of actual investment gains.

Are all major stock market indices free-float adjusted?

Many, but not all, major global stock market indexes have adopted a free-float adjusted methodology. Prominent examples include the S&P 500 and the MSCI World Index. This shift was largely completed in the early 2000s to improve the investability and accuracy of these benchmarks¹, ². However, some indices may still use different index weighting approaches or have specific criteria that result in a different treatment of outstanding shares.