News Analysis: Keeping track of Footsie rules

News Analysis: The index is about to be reformed, but there may be unforeseen consequences
CHANGING THE rules of any game is always a controversial exercise, often with unforeseen consequences. Some years ago the Rugby Union authorities decided to award five points for a try instead of four to encourage sides to attempt to score more tries rather than settling for the less entertaining three point penalty goal.

While the intentions of the authorities were honourable, rugby teams very quickly adapted to the changes and nowadays players are trained to prevent an opponent's try at all costs, even if it means committing an illegal act and giving away a penalty.

The game of investing in UK shares, as measured by the benchmark FTSE 100 index, is also about to have several of its rules changed. Again, the consequences may not be quite what the sponsors intended.

According to the game's main players - the City fund managers who control the money that will one day be our pensions - the changes are definitely for the better.

But critics believe that the rule-tinkering will further increase the investment community's already unhealthy reliance on the performance of a dozen or so multinational companies, while discouraging smaller companies with large family shareholdings from persisting with their Stock Exchange listings.

From next March, FTSE International, the keeper of the benchmark FTSE indices, will acknowledge companies that are partially owned subsidiaries of other Stock Exchange listed companies when it works out which are the largest companies in Britain.

The chief beneficiary of this change will be Freeserve, the Internet service provider that floated in July but is still 80 per cent owned by the electrical retailer Dixons. While Freeserve is listed on the stock market, for the moment it is barred from inclusion in the FTSE 250 index because of its quasi-subsidiary status.

But the more interesting and far-reaching change will take place in June 2001. From that date the FTSE 100 index, and all of the FTSE indices, including the All-Share, will restrict the weighting of stocks according to the amount of free floating shares available. In layman's terms this means a company's relative importance within the index will be calculated solely on how many of its shares can actually be bought or sold.

For instance, Colt, the telecoms company, will only have half of its pounds 8.8bn market capitalisation counted towards the index because 52 per cent of the company is still held by the venture capital house Fidelity.

Market analysts reckon the changes will affect "structural" equity stakes worth pounds 26bn, including those in householdnames such as Associated British Foods, BSkyB and Orange, all of whom will see their relative importance in the FTSE fall.

However, the move will not affect whether a company is actually included in the top 100 companies, which will still be decided by overall market capitalisation. "In a nutshell, it will produce a level playing field," says David Rough, investment director of Legal & General, one of Britain's largest fund managers with pounds 93.6bn under management.

The changes have been made following a three-month consultation exercise involving 130 fund managers, trade associations and companies across 17 countries. While the majority of respondents gave the thumbs-up to the changes, the most ardent supporters, by a factor of six to one, were the fund managers.

So why the fuss about what seems to be a minor technicality? The answer lies in the sea change that has taken place in the way money is invested in Britain. Indices now rule investment, with most fund managers having to keep a large proportion of their holdings spread across the FTSE to ensure that their fund's quarterly performance is at least close to that of the market. Fewer are willing to go out on a limb and invest heavily in particular stocks for fear of underperforming the index and losing a key pension fund mandate.

L&G has an even bigger headache, being one of Britain's biggest providers of index-tracking savings products. According to Mr Rough, it is becoming harder to maintain correctly weighted positions in some FTSE 100 stocks because their total market capitalisation - the current benchmark for the relative importance in the index - is so far in excess of the number of shares one can buy.

"This change will end the abuse of the market by new entrants creating an artificial stock shortage by only floating a small proportion of their shares," Mr Rough says.

But some equity strategists in the Square Mile worry that the changes may cause as many problems as they fix.

"The problem comes when you look at how the index will look as a result of these changes," said Sanjiv Talwar, head of quantitative research at Commerzbank. "Ten companies, drawn from just four market sectors, will account for half of the index's weight. If, say, BP Amoco were to have a bad year, it could drastically affect the index's performance."

BP Amoco currently accounts for about 9.24 per cent of the index; under the new rules it will have closer to 9.5 per cent. This increase may not sound like a big deal, but actually it is the equivalent of BP Amoco taking over British Steel. Other companies which will see their relative importance rising include Glaxo Wellcome, Shell, BT, Vodafone AirTouch, and HSBC, all of which have almost 100 per cent of their shares in circulation.

"The real problem is not the weighting that is given to those stocks, the problem is that the index itself is not the perfect portfolio," admits Jeff Saunders, UK equities chief at Standard Life, which invests pounds 70bn on behalf of Britain's savers.

Some analysts also worry that smaller companies with major family shareholdings will find themselves marginalised even further by the changes, which will hasten the exit of some firms from the market via management buyouts.

"Companies will have to revisit the rationale for them being on the stock market in the first place," Mr Rough said. "I don't think that's necessarily a bad thing."

The City has just under two years in which to ready itself for the new system, plenty of time for the institutions' highly paid number-crunchers to work out how best to take advantage of it. "In the end, we will just have to suck it and see," said Mr Saunders.