Courtesy of Justin Lahart, WSJ
You would think that the whole point of a stock index is to be, well, an index of the stock market’s performance.
But thanks to the popularity of exchange-traded funds, or ETFs, stock indexes have in recent years been doing double duty as investment vehicles. At the same time, there have been subtle but important changes in the way indexes are constructed.
Bottom line: The indexes aren’t measuring exactly what they used to.
It is a lot easier to manage an ETF if the stocks that underlie it are easily traded. If, instead, the stocks are illiquid, there is a risk their prices will get artificially inflated when money flows into the ETF. The opposite can happen when money flows out.
One step index providers have taken to bolster liquidity has been to move from capitalization-based indexes, where the weight of each member is determined by the value of its total shares outstanding, to float-adjusted indexes. In the latter, shares that are unavailable to the public (such as stock held by company directors) don’t count toward a company’s weighting. Britain’s FTSE Group made the move to float-adjusted indexes in 2000, followed by MSCI MSCI +0.51% in 2002 and Standard & Poor’s in 2005.
But while switching float adjustment may improve an index’s liquidity profile, argue researchers at New York money manager Horizon Kinetics, it may also cut into its ability to generate returns. That is because many of the companies that have added oomph to indexes like the S&P 500 in the past did so at a time when a great many of the shares were held by insiders.
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