What is free-float adjustment and why do indexes use it instead of total market cap?

Free-float adjustment modifies a company's index weight by excluding shares that are not available for public trading. Instead of using total market capitalization, the index uses only the market cap attributable to shares that the public can actually buy and sell.

What Gets Excluded from Free Float:

Formula:

> Free-Float Market Cap = Share Price x (Total Shares - Restricted Shares)

> Free-Float Factor = Free-Float Shares / Total Shares Outstanding

Example — Prescott Holdings (fictional):

In a free-float adjusted index, Prescott would receive weight based on $5.5B, not $10B.

Why Free-Float Matters:

1. Investability: Investors can only buy shares that are actually available. Weighting by total cap would overweight stocks with large locked-up portions.
2. Reduced Tracking Error: Index funds can actually replicate the weights because they can acquire the floating shares.
3. Accurate Representation: A company where 80% is government-owned should not dominate an index as if all shares were tradeable.

Major Indexes Using Free-Float:

• S&P 500 (since 2005)
• MSCI indexes
• FTSE indexes
• Most modern benchmarks

Exam Tip: Know that free-float adjustment reduces the weight of companies with large insider or government holdings. If the exam describes a company with significant strategic holdings, expect the index weight to be materially lower than total-cap weight would suggest.

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