Capital Markets

Spotty Volatility Seen from S&P Change

Some companies will experience greater-than-usual short-term price volatility after Standard and Poor's move to a float-adjusted model for weightin...
Marie LeoneNovember 4, 2004

It’s not quite the South Beach diet, but Standard and Poor’s is shedding some bulk from what have been called its “overweighted” indexes. For more than 80 years, the ratings agency has weighted companies in the widely tracked S&P 500, as well as other indexes, by full market capitalization — total shares outstanding multiplied by share price. But next year, in two stages beginning in March, S&P will adopt a float-adjusted method of weighting index companies.

According to Standard and Poor’s, the new model will exclude strategic or “inside” investors — defined by the agency as individuals or groups each holding more than 10 percent of outstanding shares — from the weighting calculations. Since inside investors hold stock to maintain control in a company, it’s reasonable that those shares should not be considered available to the public, says Lori Richards, senior product manager at Russell Indexes, an S&P competitor and the company that pioneered the float-adjusted model. An index that uses this model “is not overweighted,” adds Richards. “The float more accurately reflects the amount of shares available for trade.”

But as passive investors — primarily index-fund managers — recalibrate their holdings to the S&P benchmarks, some companies will experience greater-than-usual short-term price volatility, according to Stacey Ternowchek, senior vice president of analytical services at Thomson Financial Corp. A recent Thomson report forecasts that 105 companies in the S&P 500 will experience a one-time sell-off totaling $38 billion.

Ternowchek also expects additional short-term price volatility tied to trades by money managers who benchmark their portfolios against S&P indexes and by event-based traders who take long and short positions ahead of fund managers.

Standard and Poor’s will introduce a provisional half-float calculation on March 18, 2005; full implementation will follow on September 16. The ratings agency estimates that the changes will induce sell-offs of shares at 20 percent of the S&P 500, at 70 percent of the S&P 400 (mid-cap) companies, and at 64 percent of the S&P 600 (small-cap) companies. Observers believe that most of the trading will take place shortly before or after the two implementation dates.

Because the two float adjustments aren’t tied to company fundamentals, Ternowchek explains, the stock-price disruptions should fade quickly — probably within a week, say several experts. In fact, for most companies the adjustments will be “neutral events,” according to John McInerney, an investor relations specialist with Citigate Financial Intelligence. On the other hand, says McInerney, they will have “a very focused impact on about 30 large corporations.”

The S&P 500 companies that are the most susceptible to sell-offs are those with a relatively high percentage of insider ownership. They include Coca-Cola Enterprises, Wal-Mart Stores, Pepsi Bottling Group Inc., Goldman Sachs Group, Brown-Forman Corp., and Winn-Dixie Stores, according to officials at Standard and Poor’s, Thomson Financial, and Reuters Estimates.

Although any share-price swings are expected to be temporary, some of the asset reallocation will be significant. For instance, a recent Thomson report projects that as index-fund managers are forced to reallocate their holdings, they will sell 24.7 million shares of Coca-Cola Enterprises — nearly 48 percent of the shares held by passive investors.

“Given the amount [of investments] we manage benchmarked to S&P strategies, our trading will be significant,” comments Alex Matturri, a quantitative management strategist at index-fund manager Northern Trust. Echoing Ternowchek, however, Matturri stresses that this trading will “not be based on any fundamental view of the companies involved.”

Large companies that have a relatively low percentage of insider ownership, such as General Electric Co., Exxon Mobil Corp., Citigroup Inc., and Pfizer Inc., are likely to attract reallocated capital from index investors. On average, according to Thomson analysts, those companies are likely to see index-investor ownership increase by 4.06 percent.

As a result of Standard and Poor’s change to the float-adjusted model, the ratings agency expects that the S&P 500 will experience an average turnover in share ownership of 3.34 percent — not much higher than the 3.23 percent average for the past three years. The turnover for the mid-cap companies is forecast to average 5.22 percent, and for the small-cap companies, 5.30 percent — less than half the average turnover for those indexes for the past three years.

In addition, Standard and Poor’s expects that rolling out the new model in two phases will also spread out the effects of the changes. According to Citigate’s Brian Matt, several index-fund managers plan to benchmark their portfolios before the March and September dates to help keep a lid on volatility.

Marie Leone’s “Capital Ideas” column appears every other Thursday. Contact her at [email protected].