Providers of index trackers need to verify companies’ free float
Large companies virtually assure executive management of higher compensation. As a result there exists a perverse incentive for management to grow the absolute size (the market capitalisation) of their companies, even if this comes at the expense of returns for shareholders.
With the growth in passive investing, which tends to invest in the largest and most liquid companies, there is now an additional — yet still unwarranted — incentive for management to grow the "free float" market capitalisation because most tradable JSE indices use the shares actually available for investment to determine size.
The JSE index committee is responsible for determining the free float of each company at the quarterly index rebalancing. One potential problem is that the JSE relies on annual public disclosure by the companies themselves (despite the fact that the JSE owns Strate and could use the shareholder register to verify and update company disclosure). A second potential problem is that the passive providers appear not to verify the JSE calculations despite pouring billions of their clients’ money to track these indices.
The Resilient group of companies is an example of how corporate managers can arbitrage some indexation rules to obfuscate reality to the detriment of investors. In addition to the cross-shareholding between Resilient and Fortress (which the companies have now agreed to unwind), Resilient may have used the structure of its black economic empowerment (BEE) trusts to inflate the free float of certain group companies. This — incorrectly in our opinion — allowed Resilient to enter the FTSE/JSE Top 40 index late in 2017, with significant consequences for passive investors.
In addition to the cross-shareholding between Resilient and Fortress (which the companies have now agreed to unwind), Resilient may have used the structure of its black economic empowerment (BEE) trusts to inflate the free float of certain group companies
Resilient lent money to its BEE partner (The Siyakha Education Trust), which used the funds advanced to accumulate Resilient shares. Resilient has to date chosen not to consolidate its BEE trust and up to this point has convinced its auditor, and hence the JSE, that this is the correct accounting treatment. These shares are therefore not removed from the free float despite their not being freely available for others to purchase.
The Siyakha Education Trust holds 9.9% of Resilient, conveniently a whisker away from the 10% threshold at which these shares would automatically be excluded from the free float despite not being consolidated. To add to the suspicion, there is another very similar BEE entity (the Siyakha 2 Education Trust) that owns a further 3% or so in Resilient. If the shares of both BEE trusts are taken together (and we believe there is good reason to suggest they should be), the BEE holdings would be more than 10% of Resilient and would be excluded from the free float as per JSE rules.
What difference does it make if the JSE index committee fails to exclude the BEE shares from the free float? Passive as well as active managers managing against a free float benchmark will structurally struggle to find Resilient stock, because at least 13% of Resilient’s weight is tied up in the BEE trusts but not removed from the free float. This creates latent demand for Resilient, which is great news if you are a serial equity issuer — and your share price continues to rise. This demand is exacerbated during equity placements, particularly if (as has been alleged by some) the allocation of shares in equity placements by the Resilient Group of companies has unfairly advantaged related entities.
In December 2017 Resilient entered the Top 40 index based on its free float market capitalisation. But based on our calculations, had the free float correctly excluded the shares held by the BEE trusts, Resilient’s free float market capitalisation would have been too small to make it eligible for inclusion.
The ensuing cost to investors in a passive Top 40 product was not inconsequential. Resilient entered the Top 40 index at about R145 per share, which would have required passive managers to actively buy the shares. After its share price lost more than half of its value, Resilient exited the Top 40 index at about R65 per share in the March rebalancing. This would have required passive managers to actively sell the shares. The impact at an index level of this active buying and selling by the passive managers was more than 0.4% of performance. This loss of index return needs to be added to the passive management fee to determine the "true" costs of passive management.
Investors in passive products should be asking passive providers whether, as a matter of course, they independently check the validity and integrity of the indices they are tracking, including the calculation of each company’s free float. The correct calculation of the free float appears to be child’s play compared with the detection of fraud the active management community is expected to police. The answer that "we rely on the JSE" would be tantamount to active managers arguing that "we rely on the auditors" to detect fraud.
• Lambridis is portfolio manager at Prudential Investment Managers.