What Have They Done to My Index Fund?

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 mutual 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 mutual 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 capitalization based on the company's total value, or just the value of the shares available on the open market?

Why the Float Matters
That's 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 5 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 9 million of them available on the open market. Thus Company B's float is 90%. (For more on why and how companies keep shares out of the public's hands, see the article "Why Some Stock Shares Are Out of Your Reach.")

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 mutual 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.com (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. (To look up a company's number of shares outstanding and its float, see the Short Interest section at the lower right corner of its Quote page on Morningstar.com.) The nonpublicly 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 nonfloat shares, is used to determine whether it belongs in the index.)

Not Just for Stocks
Although most of the stock indexes that mutual 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 mutual 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. As a result, in 2010 widely held  Vanguard Total Bond Market Index (VBMFX) switched to a float-adjusted version of the Barclays Aggregate Bond Index. Meanwhile other companies continue to use the non-float-adjusted version of the index for their mutual funds and ETFs. (Performance between the two doesn't vary much; the float-adjusted version of the index lost 0.21% for the 12-month period ended April 25 and the non-float-adjusted version lost 0.22%.)

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 mutual 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 mutual 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.

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