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Free float index

What is the free float methodology for calculating the weights of different stocks in the

index, and how is it different from the earlier market capitalisation based method

The BSE Sensex shifted to the Free Float Methodology from the first of this month(sep2003). This shift to the new method attracted much attention though all the hype and

hoopla was hard to understand since the switchover did not change the value of the

index nor did it impact to a very great extent the fortunes of the various scrips

comprising the index. It is therefore necessary to understand what this change is and

what it means. We will also evaluate the impact of this change.

It is well known that the BSE Sensex is an index comprising of 30 key stocks. Further,

the BSE Sensex is a market capitalization based index, i.e. the calculation of the index

takes into account the market capitalization of each scrip in the index and the change

therein. Moreover, the weight each scrip carries in the index is dependent on the ratio of

the scrip's market capitalization to the Index's market capitalization. Thus, under the

method prevailing before September 1, the total market capitalization of each scrip was

considered for purposes of index calculation.

Analysts however had a problem with this method. The argument against this method

was that a large proportion of the outstanding capital of the company was locked up

with promoters, strategic holders, government, etc and was not available for trading in

the market. Therefore, felt market pundits, it would be incorrect to calculate the total

market capitalization of a company. It was therefore suggested that the free floatmethod be adopted to calculate the index. The free float method takes into account only

that number of scrips that are available for trade in the market.

To calculate the Index based on the Free Float Method, the BSE assigned Free Float

Factors to each scrip. These Free Float Factors determine the percentage of total

market capitalization of the scrip that would be taken into account for the purposes of

index calculation. For this purpose the BSE has worked out a disclosure format which

each company is supposed to submit to the BSE every quarter. The BSE then slots

each company into any one of the nine categories it has created. Each of these

categories has been further assigned a 'Free Float Factor'.

The moot question however is what advantage the new method offers. The shift to the

new method is considered good because it now truly reflects an investable index.

Further, it also removes the influence of a closely held large cap stock on the index.

Also, it reflects market movements better and enables passive investing since the index

is replicable.

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In fact, this change in the Index methodology directly impacted passive investment

vehicles- Index Mutual Funds. The switch over to the new method changed the

weightage of each scrip in the BSE Sensex. Since Index Mutual Funds are supposed to

precisely replicate the underlying Index, Mutual Fund Schemes based on the Sensex

would have been required to sell holdings that have lost weight and buy stocks that

gained weight in the Index.

Such buy and sell activity from Index Fund Managers and from other fund managers

using the Sensex as the benchmark should have impacted prices of affected scrips.

However, not much impact was observed, particularly on scrips that lost weight, since

the momentum of the ongoing rally was very strong.

The change to the free float method has impacted the weightage of various scrips in the

Sensex. Scrips that have gained weight in the index include ACC (Free float factor -0.9), Bajaj Auto (0.8), Dr Reddy's Labs (0.8), HDFC (1.0), Hindalco (0.8), ICICI Bank

(1.0), Infosys (0.8), Larsen & Toubro (0.9), Satyam (0.9) and Tata Steel (0.8).

Scrips that have lost weight include BHEL (Free Float Factor - 0.4), BSES (0.5),

Hindustan Lever (0.5), HPCL (0.5), MTNL (0.5), Nestle (0.5), SBI (0.5), HCL

Technologies (0.3), Castrol (0.3) and Zee Telefilms (0.5). The Free Float Methodology

is now also being viewed as a global practice. Widely watched and used indices such

as the MSCI Index, FTSE, Nasdaq 100 etc make use of the Free Float methodology