Money managers praise S&P for float-adjusted index weightings

NEW YORK — Money managers are praising the Standard & Poor's plan to shift three major indexes to float-adjusted weightings from all-share weightings.

"I think it's a good thing. It's reality," said Tom Durante, senior portfolio manager at Mellon Equity Associates LLP, Pittsburgh. The firm manages $12 billion in passive equity strategies, including $11 billion pegged to the affected indexes — the S&P 500, S&P MidCap 400 and S&P Small Cap 600.

Managers also are pleased the changes will take place over an 18-month period, giving them plenty of time to adjust their portfolios. They agreed that having a more realistic index is an advantage that will far outweigh such disadvantages as increased turnover and additional one-time trading costs.

"There are no real negatives to this," said Peter Leahy, director of global indexing at State Street Global Advisors, Boston.

"This move is in the right direction of best practices because it will make the indexes more representative of what you can buy and hold. And the way S&P is pre-announcing and implementing this over a long period of time is good in terms of transparency and reducing volatility." SSgA managed $522 billion in passive equity strategies as of Dec. 31, including $173.6 billion pegged to the three indexes.

Under the plan, each company in the three indexes would be weighted according to how much of its stock is available to be sold to the public. Big chunks of many companies in the index — such as Wal-Mart Stores Inc., with 38.9% held by insiders and Coca-Cola Enterprises Inc., with 48.1% held by insiders — would not be included in the new weightings.

Currently, companies are fully weighted by market capitalization, regardless of how much of that capitalization is owned in the public markets. "You can't buy a lot of those shares because they don't trade," Mr. Durante explained.

Among the stocks that will be most affected are Wal-Mart, which is closely held by the founding Walton family, and United Parcel Service Inc., whose employees own a stake through their ESOP. Wal-Mart's current weight in the S&P 500 would be reduced to an estimated 1.55% from 2.44%, and UPS would drop to an estimated 0.38% from 0.73%, according to calculations from Phil Jamison, New York-based U.S. portfolio strategist at Dresdner Kleinwort Wasserstein, London.

At the same time, weightings will rise for companies without large closely held stakes. The big gainers, according to Mr. Jamison: General Electric Co., which will climb to 3.27% of the indexes from 3.07%; and ExxonMobil Corp., to 2.78% from 2.62%.

David Blitzer, managing director and chairman of the S&P Index Committee, said in an interview that a number of details are still being worked out. However, there is a plan to calculate provisional, or temporary, float-adjusted indexes for use as interim benchmarks if investors choose.

S&P decided to shift to float-adjusted weights because many company investors wanted it, Mr. Blitzer said. "Some pension consultants had told their pension funds they couldn't use our indexes because they weren't float-adjusted, which we took into consideration," Mr. Blitzer said. However, several consultants contacted by P&I had not heard of pension funds unable to use S&P indexes.

James McKee, vice president-capital markets research at Callan Associates, San Francisco, said he doesn't believe not having a float is a material event for investors in U.S. indexes, because, "in the U.S. you don't have the massive insider holdings you do in countries like Germany and Japan … to sacrifice liquidity to do this is being overzealous," he said.

And Roger Fenningdorf, partner and head of research at Rocaton Investment Advisors LLC, Norwalk, Conn., said, "We prefer a float-adjusted index because it's a better reflection of what can be traded in the market. We think the change is a positive. But given the dominance of the S&P 500 in the U.S., that's been the de facto proxy and we've always used it."

Float-adjusted indexes — such as those offered by Russell Investment Group, Tacoma, Wash. — have become more popular with investors in the past six to eight years, Mr. Blitzer added. "The research S&P conducted on changing the weightings suggested that there would be no substantial change in the level of risk or performance."

The changes will result in a reduction in the total market capitalization of the S&P 500 to about $9.9 trillion, a drop of around $800 billion, estimated Patrick O'Connor, senior portfolio manager in the indexing group at Barclays Global Investors, San Francisco. He noted these are preliminary numbers and that S&P hasn't yet said how it is doing its calculations.

The impact on the other two indexes would be a lot less. The MidCap 400 would be reduced to $870 billion from $1.03 trillion and the Small Cap P 600 would be reduced to $379 billion from $457 billion.

At BGI, "we'll treat the changes like any other rebalancing, and look for liquidity. We may look to add value and develop trading strategies. But depending on what happens, we may not need strategies," Mr. O'Connor said. "We might wait to trade if a stock is oversold. We don't want to crush a stock." BGI has $584 billion in passive equity strategies; of which $218.5 billion is pegged to the three affected indexes.

Mr. O'Connor and other managers observed that the long phase-in is being done to mitigate volatility. But they cautioned it's impossible to say how much volatility could result from the changes.

The biggest impact will come in trading, said Mellon's Mr. Durante. "Passively managed funds will have to buy and sell the affected shares to get to the correct weightings. But active managers may also be doing a lot more trading, because they might not want to be overweight … on a stock such as Wal-Mart, even if they like it. They may want to be neutral. It could get very volatile."

While index managers won't buy and sell the affected stocks until the changes are official, he said, it's possible active managers will jump the gun.

S&P's Mr. Blitzer said the average turnover of the S&P 500 index is 5% a year. That could increase to 10% for about a year as the changes are implemented. "We're comfortable that the turnover is manageable," said Mr. Blitzer.