Funds: Watch out for hidden index changes
Aug 29, 2012
If you avoided buying Facebook shares, which have fallen by 58% since their May flotation, congratulations. But what if you ended up owning them without realising it, let alone wanting to? Exchange-traded fund (ETF) investors need to watch out – the way in which index providers tempt new companies to join their index (which is then tracked by the relevant ETFs) may not work in your favour.
Index eligibility rules may sound pretty technical – but they matter. The potential to be included in a particular index can be attractive to firms deciding where to list their shares and to index providers trying to build a profile. Facebook announced in April this year that it was choosing the heavily technology-biased US Nasdaq exchange as the place it wanted to list. And, seemingly just in time for this huge initial public offering (IPO), the exchange stated that it was loosening its “seasoning rules” for inclusion in its biggest index. Previously, Nasdaq had required newly listed firms to wait at least a year until they could enter the widely followed Nasdaq 100 index. In the spring the exchange declared that a three month wait would suffice. Although the exchange denied it, the rule change looked like a sweetener to attract Facebook’s business.
In London in recent years the British regulator has been willing to waive a requirement for newly listed firms to have at least 25% of their shares available for public trading (known as the minimum ‘free float’) as part of a push to attract business from emerging markets. This helped several large, commodity-focused overseas firms to sell their shares on the London Stock Exchange while offering only a thin sliver of their equity to the public. A few (ENRC, Essar, Fresnillo) also made it into Britain’s benchmark FTSE 100 index.
Grumbles about poor corporate governance at some of these firms prompted index provider FTSE to announce that it was unilaterally tightening its rules to ensure a minimum 25% free float once more. British listing standards are now getting tighter again in other ways too. But in America (think of Facebook, Google, or Man United) there’s nothing to stop firms issuing share classes with, say, no voting rights or dividends, and still getting them into a big index.
As the volume of money in tracker funds grows ever larger, it’s especially important to find out and monitor how the benchmark indices they follow are put together. Otherwise you could end up inadvertently tracking a plummeting Facebook or dodgy Russian mining stock.
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