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:

Excluded Shares	Example
Government holdings	State-owned enterprises
Founding family stakes	Locked-up insider shares
Strategic cross-holdings	Company A owns 20% of Company B
Restricted employee shares	Unvested stock grants
Treasury shares	Company's own repurchased shares

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):

Item	Value
Share price	$50
Total shares outstanding	200 million
Founder family holds	60 million (locked)
Government stake	20 million
Treasury shares	10 million
Free-float shares	110 million
Total market cap	$10 billion
Free-float market cap	$5.5 billion
Free-float factor	0.55

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.

Practice index construction questions in our CFA Level I bank.