The Bombay Stock Exchange's move to reconstruct the Sensex on the basis of a float system is in the interest of the investors. Currently, the Sensex is based on a model of asset pricing in which the market capitalisation is the main determinant.
In this model, index constituents are included at full market capitalisation weight (a company's total shares outstanding multiplied by its market price). The ratio of the constituent's full market capitalisation divided by the sum of the market capitalisation of all the index constituents in the index is the weight.
From September 1, the Sensex will be reconstructed using a 'Float weighting' system. The major difference is that the float weighting system subtracts out shares that are closely held or cross-held by other public companies.
An Investable Weight Factor is used to adjust for free float so that only the free float of a company is included in the index portfolio. Free float being defined as the percentage of each company's shares that are freely available for trading in the market.
So these can be seen as the contestable shares in the marketplace for each company.
Weighting shares according to their free float enables indices to more accurately reflect the effective trading opportunities for investors, thereby improving their investability and transparency.
The 'float' adjustment makes an index a better benchmark because it represents the set of opportunity available to all the investors in a well-defined manner. The two approaches yield differences in the relative stock weightings in one index versus another.
Under the free float methodology, the Sensex will show what is available to investors and how that set is moving. Even a back of the book calculation shows that there will be changes in the composition of the index as well as the weightage accorded to the companies.
With its new methodology, the Sensex will now represent an investment opportunity set for the investor -- retail and institutional. Earlier, even though it may have been treated as one, it was not quite that.
With a market capitalisation base, the Sensex was designed to be nothing more than a lightweight index which amplified the equity market movement.
Now, it can legitimately be seen as a benchmark that is a representative index of the investment opportunity set. At the same time, it will continue to be a lightweight index that amplifies market movements.
The move to the float system will also make the index more reflective of the investors' investment strategy besides being the benchmark for investment performance measurement. Already fund managers are planning to pare their exposure to the erstwhile index heavy weights.
FIIs allocations will also undergo a change as these are based on the index weightages. It will be more useful now that it can be seen as an investable benchmark.
By moving over to the float system, the index has the potential to serve as an indicator for all market participants in different segments of the equity markets, to benchmark their performance against it; find out the attributes for the variation in their performance against the index and reshuffle their portfolio, keeping in mind their risk-reward preferences.
It can provide the market participants with a convenient and realistic tool for the capture and analysis of the market movements and their corresponding effect on portfolio consisting of a wide range of stocks.
All this will make it relevant and take it away from the one-information-byte-index which tells us precious little by its up, down or sideways movements.
While it is clear that for purposes of the float, shares held by governments, strategic partners or other control groups will be excluded from the company's share outstanding, there are also some gray areas.
For instance, how to deal with shares owned by other companies and whether these will be excluded regardless of whether they are index constituents or not.
Will stocks be adjusted for the foreign investment limit that may exist at the national level for strategic companies or industries, or for company by-laws limited foreign investment. In such cases, the investable weight factor will have to reflect the foreign investment limit.
Also, how the long-term investors (other companies' holdings, pension funds, insurance companies, employee shares) with more than 5 per cent ownership are treated, will have a bearing on the extent to which the index becomes an investment opportunity set.
In addition to the construction of the index, there are issues in index managements such as the revisions to companies' IWF. Ideally, this should be only once a year, to avoid frequent rebalancing on the part of fund managers.
The IWF may be revised, driven by corporate events like mergers or if there is a major event that changes a stock's weight dramatically, like a privatisation, whichever is the more restrictive.