Understanding Passive Funds

ETFs and trackers mirror the performance of a given index. But simple as this may sound, building indexes to match market performance isn't always straightforward

Adam Zoll 29 April, 2014 | 12:43PM
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Question: When reading fund reports I sometimes find references to float-adjusted, spliced, or composite indexes. What do these terms mean?

Answer: On the surface, the way most index passive funds and exchange-traded funds work isn't all that complicated. They simply seek to track the performance of a given index by owning the same constituents in the same proportion as the index. Often this is done using market-cap weighting, meaning that the percentage of the portfolio allocated to each security is in proportion to its size relative to the other holdings. For a passive fund or ETF that tracks a market-cap-weighted equity index, such as the S&P 500, a company whose market cap represents 5% of the index's total market cap would make up 5% of the portfolio.

But simple as this may sound, building indexes to match the performance of a given market segment isn't always so straightforward. For example, what if only a portion of a large company's shares are available to the public? Should the index treat the company's market capitalisation based on the company's total value, or just the value of the shares available on the open market?

Why the Float Matters

That is where float-adjusted indexing comes in. A stock's "float" refers to the percentage of its shares that are publicly traded. Let's say Company A issues 10 million shares, of which only five million are publicly traded with the rest held by insiders and other major investors. One would say that the float for Company A's stock is 50%. Company B also issues 10 million shares of stock but makes nine million of them available on the open market. Thus Company B's float is 90%.

Now let's assume that Company A is included in a stock index that is market-cap-weighted. Only half the company's shares are available to outside investors, so the index weights the stock according to these shares only. The shares that aren't available to outside investors, including passive funds and ETFs, are excluded. This method of including only publicly traded shares in the index is known as float-adjusting the index, sometimes also called free float-adjusting.

An example of a company in which float-adjustment comes into play is  Amazon (AMZN). The online retail giant's overall market cap is estimated at around $130 billion. However, only about two thirds of its shares are publicly traded. The non-publicly traded shares, controlled by insiders such as founder and CEO Jeff Bezos, would not be included when determining a company's weight in a float-adjusted index. Incidentally, a company's full market cap, including both its float and non-float shares, is used to determine whether it belongs in the index.

Not Just for Stocks

Although most of the stock indexes that passive funds and ETFs track are float-adjusted, the same technique may also be used for bond indexes. For example, in the wake of the 2008 financial crisis, as the Federal Reserve began buying trillions of dollars in mortgage-backed securities as part of its quantitative-easing program, Vanguard announced it was switching to float-adjusted versions of the indexes used for its bond passive funds and ETFs. The move was designed to account for the fact that the market for investable taxable bonds had shrunk as a result of so many mortgage-backed securities being taken out of the market. Meanwhile other companies continue to use the non-float-adjusted version of the index for their passive funds and ETFs. 

More Fun With Indexes

When looking over literature from your fund company you may also come across references to a ‘spliced index’ – for example, a benchmark against which to measure the performance of the company's own passive funds and ETFs. A spliced index is one in which the performances of two or more indexes have been linked together to achieve a longer series of historical results. 

Splicing may be done because a currently used index doesn't go back far enough in time, requiring the addition of data from an older but similar index. Or it may be done because the fund company changed indexes at some point, requiring that data from the two indexes be combined. For example, to benchmark some of its emerging-markets passive funds and ETFs, Vanguard uses a Spliced Emerging Markets Index that consists of performance data from the Select Emerging Markets Index (up to August 2006), the MSCI Emerging Markets Index (up to January 2013), the FTSE Emerging Transition Index (up to June 2013), and the FTSE Emerging Index (up to the present).

Finally, the word ‘composite’ in an index may be used to indicate that it represents the overall performance of a broad group of securities, often those listed on a particular exchange. For example, the Nasdaq Composite Index tracks all the stocks listed on the Nasdaq while the NYSE Composite Index tracks all the stocks listed on the New York Stock Exchange.

 

This article originally appeared on Morningstar.com

The information contained within is for educational and informational purposes ONLY. It is not intended nor should it be considered an invitation or inducement to buy or sell a security or securities noted within nor should it be viewed as a communication intended to persuade or incite you to buy or sell security or securities noted within. Any commentary provided is the opinion of the author and should not be considered a personalised recommendation. The information contained within should not be a person's sole basis for making an investment decision. Please contact your financial professional before making an investment decision.

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Securities Mentioned in Article

Security NamePriceChange (%)Morningstar
Rating
Amazon.com Inc184.70 USD0.58Rating

About Author

Adam Zoll  is an assistant site editor with Morningstar.com, the sister site of Morningstar.co.uk.

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