A Case for a Free Float-adjusted Market Capitalization Index

The current NSE Index is a value-weighted capitalization Index. What this means is that the movement of the Index is determined by the effect of all the stocks that are listed on the exchange according to their percentage weighting. The higher the market cap of a stock the higher the effect it will have on the overall performance of the Index.

Dangote cement was listed in October and now holds about 25% of the market capitalization. This in effect means that out of the total 5% potential daily movement of the Index Dangote cement commands 1.25%. If the whole market stays stagnant and Dangote cement alone gains 5%, the NSE Index will rise by 1.25%. That is a whole lot of bias in favor of a single stock with 95% held by only one person.

Portfolio managers whose performance are measured against the NSE Index will therefore have to hold some Dangote cement in their portfolios whether the like it or not, in order to reduce tracking error risk. If they don't like the company and the stock decides to do a bullish run, the portfolios managed will drag even if they contain companies with far better fundamentals than Dangote cement.



This brings me to the conclusion that it is high time the NSE Index is changed from its current value weighting to a float adjusted weighting system. A float adjusted weighting system will calculate the Index movement based strictly on the free float of shares available for investment on the floor of the exchange and this will be a better reflection of the investable universe of stocks.

A Dangote cement with only 5% available for investment will no longer be in a position to hold all of us to ransom and if we don't like it but still need to expose our portfolios to the building sector, we can buy something else without tying ourselves to an overpriced stock.

It should be noted that this change is going to be in line with current global best practices as exemplified by the S&P 500 Index, S&P MidCap 400 Index, S&P SmallCap 600 Index and the Japanese TOPIX.

Caveat: This is not an investment recommendation for the purchase or sale of Dangote cement. I just used it as an example of how the Index will more accurately reflect the movement of an investable asset.