S&P Adopts Free-Float Weighting

Standard & Poor's, perhaps the most important stock indexing company in America, has made a change in the way it operates. Starting this week, the S&P 500 and its other indices will use a free-float weighting system. While this sounds rather arcane, and is unimportant in day-to-day trading, for long-term investors, this is a significant step forward, even if it doesn't go quite far enough.

When creating a stock index, the indexing company is trying to link together the equity securities of various companies to reflect their relative importance to the economy or a sector of the economy. The result allows investors to play the broader market rather than picking individual stocks. Or in the case of sector indices, it facilitates a sector play. From time to time, an indexing company will alter the weighting or replace a stock with one more relevant -- this reflects the dynamic nature of the economy.

Free-float weighting represents a more fundamental change than merely shifting the emphasis form one stock to another or shifting a dying stock out and bringing a vibrant one into the index. Free-float weighting takes some of the emphasis off stock that is held by insiders, whose shares rarely get sold and, therefore, don't really play a part in trading.

The new S&P rule omits about half the shares insiders hold when index calculations are done. As a result, companies with some concentration in insider hands have fewer shares trading, and therefore, fewer shares wind up in the index. Because the Walton family still has around 40% of the stock in Wal-Mart, it isn't realistic to treat their 40% as tradable stock because they aren't selling. Wal-Mart's relative weighting in the S&P 500 is down around 0.35% as a result. Microsoft is still 9% the property of Bill Gates, and this is reflected in the 0.13% decrease in Microsoft's weighting.

However, this really doesn't go far enough. A further refinement is necessary to keep the indices accurate, and that is to change the weighting so that the 50% of insider stock excluded is changed as and when the SEC forms for insiders sales are filed. For most retail traders, this is irrelevant, but to the biggest institutions, this refinement will make their models that much more reflective of reality. And where the sharks swim, there are the pilot fish. That said, the free-float weighting is one of the best ideas anyone on Wall Street has had in quite a while.


© Copyright 2005 by The Kensington Review, J. Myhre, Editor. No part of this publication may be reproduced without written consent.
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