FREE-FLOAT ADJUSTMENT: UNDERSTANDING INSIDER EXCLUSION

Why Insider Shares Are Excluded

Free-float adjustment is a critical concept in the world of equity indexing and financial analysis. It refers to the method by which the market capitalisation of a listed company is modified to reflect only the shares that are available for public trading. Shares held by company insiders, governments, or other strategic entities are typically excluded from the float because they are not freely available on the open market.

In this context, 'insiders' usually denote company executives, directors, and other individuals or entities with significant control over the company. These shareholders are assumed to have a long-term interest in the company and are not expected to trade their holdings frequently. Therefore, their shares are not reflective of the true liquidity and trading potential of a company's stock from a public market perspective.

This approach differs from total market capitalisation, which includes all outstanding shares regardless of ownership. Let us explore the reasoning behind this difference:

• Liquidity: Free-float more accurately represents the liquidity of a stock. Accurate float data helps institutional investors assess investment opportunities based on realistic supply and demand dynamics.
• Market Efficiency: By excluding shares that are locked away and unlikely to trade, free-float market cap reflects the portion of a firm’s equity that sets prices in the open market.
• Index Accuracy: Index providers like MSCI, FTSE Russell, and S&P Dow Jones use free-float adjustments to construct more representative and investable indices. Companies with smaller public floats will carry proportionally lower weights in indices, even if their total market cap is large.
• Reduced Manipulation Risk: Insider-controlled shares could potentially distort indices if included in full, giving a false sense of market exposure or liquidity.

The exact definition of 'non-free-float' shares can vary slightly between index providers. As a general rule, however, the following are commonly considered non-free-float:

• Strategic shareholdings by government entities
• Holdings by company directors and board members
• Shares held under lock-up agreements
• Cross-holdings by subsidiaries or other group companies
• Founders’ stakes and long-term private placements

Since these shares are not expected to change hands frequently, they are excluded from the count of free-float, which directly affects a company’s weight in indices and its valuation from an investor's point of view.

In sum, excluding insider holdings provides a cleaner view of a security’s actual float and improves the integrity of market tracking tools and indices.

How Free-Float Market Cap Is Calculated

To understand how a company’s index weight or public market presence is evaluated, it is essential to grasp how free-float market capitalisation is calculated. The formula is relatively simple:

Free-Float Market Capitalisation = Share Price × Free-Float Shares

Here, free-float shares represent only those shares available for trading in the open market. The methodology requires determining the proportion of the company’s total shares that are classified as free-float. This proportion—called the free-float factor or adjustment factor—is then applied to the total market capitalisation.

Let us delve deeper using a hypothetical example. Consider a firm with the following attributes:

• Total Shares Outstanding: 500 million
• Total Market Price per Share: £10
• Shares held by insiders and strategic investors: 200 million

The number of free-float shares = 500 million – 200 million = 300 million
Therefore, Free-Float Market Cap = £10 × 300 million = £3 billion

Compare this with the total market capitalisation: £10 × 500 million = £5 billion. In this case, the free-float cap is 60% of the total market cap. Index providers would use the £3 billion figure to determine the company’s weight in an index rather than £5 billion.

Free-float factors are typically rounded into bands for consistency. For example, FTSE Russell uses several float bands such as 5%, 15%, 25%, and so forth. These bands make computation and index construction more transparent and manageable while accounting for approximate float proportions.

Here’s how the process typically works in institutional index construction:

1. Determine total shares outstanding
2. Identify and subtract strategic, locked-in, or non-publicly tradable shares (typically disclosed in annual filings)
3. Apply a float banding methodology (e.g., 50%-75%)
4. Multiply the float-adjusted shares by the prevailing share price

It is important to note that free-float is not static. Insider activity, share sales, or the expiration of lock-up periods can alter a company’s float. As such, index providers periodically review and update free-float factors—semi-annually or quarterly—depending on the methodology of the specific index.

This calculation model allows investors to see a more realistic picture of what capital is actually influencing share prices through public trading, which improves both portfolio construction and risk management for institutional and retail investors alike.

How Index Providers Use Free-Float Data

Most global index providers employ free-float methodology to assemble and maintain their indices. This practice ensures that resultant indices are reflective of the amount of capital accessible on public markets and are thus more replicable by institutional investors and asset managers.

Major indices that incorporate free-float adjustment include:

• S&P 500 (Standard & Poor’s)
• FTSE 100 and FTSE All-Share (FTSE Russell)
• MSCI World and MSCI Emerging Markets (MSCI Inc.)
• STOXX Europe 600 (Qontigo)

These indices exclude or reduce the influence of shares not ordinarily traded, recognising that they do not contribute to price discovery or investment opportunity in the same way as shares freely available on the market.

Here is how index builders typically utilise free-float data:

1. Determining Index Weighting

Constituents within an index are weighted according to their float-adjusted market cap. For instance, two companies with similar total market caps may have different index weights if one has a significantly larger free float.

2. Screening for Eligibility

Some indices may impose minimum float requirements as a condition for inclusion. A company with an excessively small free-float ratio might be excluded altogether from certain indices, even if its overall size meets other inclusion criteria.

3. Managing Turnover and Rebalancing

Free-float reviews typically occur quarterly or semi-annually, depending on the provider’s methodology. When insider holdings shift, or when lock-up periods expire post-IPO, float percentages are re-evaluated, leading to potential reweighting or reclassification within indices.

For example, following a large insider sell-off, a company's float might expand, warranting a higher weighting in an index. Conversely, an increase in strategic holdings, such as those from a controlling shareholder or government agency, might trigger a downward float revision.

4. Tracking and Replication Ease

From an asset-management standpoint, using free-float-adjusted benchmarks improves the tracking accuracy of index funds and ETFs. Since these funds physically or synthetically replicate indices, knowing the actual investable base is crucial for portfolio construction.

5. Enhancing Market Transparency

By focusing only on publicly tradable shares, indices based on free-float adjusted metrics provide clearer insights into investor sentiment and trading dynamics, free from the distorting effects of locked-in insider and strategic holdings.

Ultimately, free-float methodology plays a vital role in modern portfolio theory, index fund design, and regulatory compliance. It contributes to the objective of maintaining indices that are liquid, representative, and aligned with global investment standards.

In summary, this adjustment refines market cap-based measures to better reflect the actual influence of a security on public markets, ensuring both institutional and retail investors operate with accurate, actionable information.