Free float: The market's missing factor

The regulatory definition of public float needs to align with the market practice of free float

India’s capital markets have grown in step with its economy, expanding from 70 per cent of gross domestic product (GDP) in 2012 to 105 per cent at present. That financial development is inextricably linked to economic growth is a stylised fact. Consequently, the ambition of becoming the third-largest global economy by 2027 warrants a vibrant equity market, notably one that is highly liquid. Liquidity in markets aids price discovery and mitigates the risk of price rigging. Better price discovery translates into a more accurate estimate of a company’s market capitalisation.

Measures taken by the Securities and Exchange Board of India (Sebi) to improve liquidity in Indian equity markets have borne fruit but it is an unfinished agenda. The Sebi (Listing Obligations and Disclosure Requirement) Regulations, 2015, mandate listed companies to have a public float, a minimum public (non-promoter) shareholding, of 25 per cent. A higher non-promoter holding likely leads to increased trading in a company’s stock, resulting in better price discovery. It is no wonder that in the 2019 Budget, the Finance Minister called for increasing the public float to 35 per cent.

However, unfortunately, a higher non-promoter holding does not automatically lead to a larger number of shares available for trading. Several entities, billed as non-promoters, hardly trade their holdings! These include group companies, associate companies, employee trusts, and strategic shareholders. Public float, therefore, overstates the number of tradable shares. Alternatively, free float — which takes into account the actual number of shares available for trading — addresses this issue. Numerous index providers and exchanges, including the NSE, MSCI, Dow Jones, FTSE, and S&P, employ the free-float criterion rather than public float to determine their index constituents’ market capitalisation.

Trillions of dollars are riding on index funds and exchange-traded funds (ETFs) mimicking various indices. This necessitates the component stocks of these indices to be sufficiently liquid, or else rebalancing of passive funds becomes a nightmare and value-destroying. Therefore, using free float to compute index constituents’ market capitalisation assumes critical importance.

It is high time the regulatory definition of public float was aligned with the market practice of free float. The authors analysed a sample of over 1,000 NSE-listed companies over 2011-2022 to find that the average public float of Indian companies stood at about 46 per cent, whereas the average free float was at 38 per cent, a difference of about 8 per cent. Imagine an 8 per cent increase in trading volumes on exchanges!

Our analysis shows that free float positively impacts stock liquidity across several dimensions, such as breadth, price impact, and bid-ask spread. We estimate that if the gap between public float and free float reduces by 1 per cent, it leads to an improvement of 0.52 per cent in price impact and 0.22 per cent in breadth on average. 

Historically, crises have been characterised by liquidity dry-ups and the default remedy for regulators being its restoration. Our analysis reveals that during the recent Covid crisis, the stocks with higher free float experienced a smaller drop in volumes. So, the free float can act as an absorber of liquidity shocks.

Other things being equal, stocks with higher liquidity will likely be valued higher due to increased trading. The lack of trading renders discovering true or fair prices of assets suspect. On average, we find that a 1 per cent decrease in liquidity can lead to a 27 per cent discount in the value of the stock.

An overlooked issue is the composition of free float. Which components of free float matter more? The institutional or the retail investor? Within institutions, the foreign institutional investors (FII) or the domestic institutions (DII)? In Indian stock markets, institutional ownership size and influence have steadily grown. While institutional ownership was once dominated by FIIs, DII holdings have been increasing of late.

The popular perception is that in the aftermath of the Covid crisis, DIIs have “arrived” and have taken the wind out of the sails of FII influence in the markets. Our analyses tell a different story, though. The FIIs continue to dominate, and the stocks having larger FII presence in free float experience higher and more durable liquidity.  Taken together, institutions remain a mighty force in the Indian markets, and their interest (or the lack of it) is seen by the market as a signal about the stock’s potential. After all, newbie traders are taught from day 1 to “follow the big guys”. The NSE data shows that over 2011-2022, the institutions commanded the lion’s share of turnover in the market at 24 per cent.

What about retail investors? They have risen in number and grown manifold post-Covid. The number of demat accounts has almost tripled since 2020. The weighting of retail investors in free float has also witnessed a steep rise, surpassing that of institutional investors from 2020 onwards.

 The retail renaissance in the markets is undoubtedly remarkable. We find that during the crisis, it is the retail investors who turned suppliers of liquidity in the markets, the big guy’s burden traditionally. Who could have foreseen that the retail investors would actually supply liquidity when the market needed it the most? Is this here to stay? No one knows. If it does, then it calls for a more robust framework to protect small investors from manipulation by the high and mighty. The green shoots of equity culture among the masses augur well for the economy and need tending with careful regulatory vigilance.

In conclusion, the regulatory focus should be on increasing the free float. Simply aiming at increasing the shareholding of non-promoters will not suffice. Without an adequate level of free float, one can’t have a deep and liquid market, which is a must to keep the positive Indian equities market story going.

The writers are, respectively,  associate professor at XLRI Delhi; professor at XLRI Jamshedpur; and former chairman, Sebi