Float weighting was developed because the surge in assets allocated to index investments has become so large that distortions in the market can develop when investors who are tracking an index attempt to take proportional positions in companies with a significant portion of their shares not up for sale at nearly any price.
An example is WalMart. The founding family holds 40 percent of the outstanding shares in this company. Although WalMart represents approximately 2 percent of the market capitalization of all the companies in the S&P 500 Index, only 60 percent of its shares will be counted in determining its weighting in the index. That free-float weighting is 1.2 percent (which is 60 percent of 2 percent).
Moreover, most small company stock indexes are capitalizationor free-float-weighted. This can distort the behavior of indexes, especially near rebalancing. For example, in 1999, a number of small technology stocks rose so quickly that they were no longer rightly considered small companies.
However, it was not until the small-cap benchmarks were rebalanced (for example, June 30, 1999 for the Russell 2000 Index) that these nouveau large-caps or nouveau midcaps could be removed from the small-cap index. Until that time, the behavior of the cap-weighted Russell 2000 Index was dominated by hot stocks rather than by well-established small-caps. In fact, in 1999, the shares of profitable companies in the Russell 2000 were losing investments as a group, while shares in companies without earnings rose in value overall.
Read More : The Newest Indexing Scheme—Free-Float Weighting
