John Spence

MSCI to Adjust Indexes for Free-Float

Morgan Stanley Capital International (MSCI) formally announced yesterday that it will adjust all of its equity indexes for free-float, a decision that will most likely trigger billions of dollars in stock turnover globally.

Under the new free-float criteria, the weighting of companies in MSCI indexes will be determined by the shares that are available for trading, which excludes shares held by governments and company insiders. Previously, a company's weight in an MSCI index was determined by the company's total market value. Under the new system, a company's weight will be calculated using only those shares that are available for purchase in the market.

When determining a company's free-float, the estimated free-float will be rounded-up to the closest 5% for securities with free-float equal to or greater than 15%. For example, a company with a free-float of 48.9% will be included in the MSCI index at 50% of its total market capitalization.

Additionally, MSCI announced that it will increase the target market representation of its indexes from 60% to 85% coverage of the relevant market on a free-float basis.

To assist managers and advisors in preparing for the free-float changes, MSCI said it will publish the enhanced index constituents and their inclusion factors on or before June 30, 2001, and a provisional index series based on the enhanced methodology shortly thereafter.

The free-float implementation will be carried out in two phases to lessen the impact of the market volatility that the move will generate. As of the close of November 30, 2001, MSCI will implement approximately half of the changes resulting from the free-float criteria for all existing index components. In addition, MSCI will on that date include all the constituents resulting from the increase in coverage to 85% at approximately half of their free-float adjusted market capitalization. The remaining adjustments will be made in the second phase to take effect as of the close of trading on May 31, 2002.

The benefit of free-float weighting over market capitalization weighting is that it gives investors a clearer picture of a company's shares that are actually available for trading. However, such an alteration to the fundamental criteria for inclusion in an index will spark a rash of buying and selling around the globe. For example, many small-cap companies with a significant number of shares held by government or insiders that comprised large chunks of an index will see their weighting in the index reduced significantly by free-float, and likely a decrease in share price as well. Conversely, the shares of underrepresented companies with a greater free-float are likely to get a boost from the rebalancing.

MSCI is the latest index provider to adopt the free-float methodology. Dow Jones Stoxx and FTSE International have recently implemented free-float weightings in their respective indexes, although each has adopted a different approach to free-float.

Yesterday's announcement will create international winners and losers, as investors alter their portfolios to reflect the anticipated changes in the index. Merrill Lynch today released a report that that detailed the estimated impact of the changes on developed market benchmarks. (Since MSCI will not release official free-float figures until June 2001, the Merrill Lynch report is based on estimated free-floats.)

As MSCI implements the adjustment to free-float indexes, Merrill Lynch predicts that Japan and France will be most aversely affected by reduced weighting in international indexes. In contrast, the U.S., the U.K., and Switzerland will see their weightings increase in the new free-float indexes.

Undoubtedly, the MSCI announcement will be followed closely by passive investors who have institutional money tied to MSCI benchmarks. Their main dilemma will be whether to endure market volatility and transaction costs as MSCI adjusts its indexes, or to simply find other indexes. Unfortunately, either decision will result in significant turnover costs.