Quick: What does an “index provider” do?
If you can’t fully answer this question, you’re not alone. For those of us who work at Dow Jones Indexes and similar firms, it’s striking to realize sometimes how little-understood our industry is. For sure, most investment professionals are aware that we calculate indexes and select the stocks that go into them. Far fewer, though, know that another crucial service we provide is ongoing index maintenance.
By “ongoing index maintenance” I’m primarily referring to a resource-intensive function that includes tracking and accounting for thousands of corporate actions—events such as mergers, spinoffs and share repurchases that affect the tens of thousands of companies that make up our various indexes. Each of these corporate actions must be accounted for in our index calculations to prevent distortions.
Below is a short Q&A primer covering “what you need to know” about the handling of corporate actions.
Q. What types of corporate actions do you track?
A. The main categories of corporate actions we track are bankruptcies/delistings, spinoffs, mergers, rights offerings, repurchase of shares, public offerings, return of capital, and special cash or stock distributions of other stocks.
Q. What do you do with the corporate action information you collect?
A. There are two main ways we account for corporate actions in our indexes. Some corporate actions require us to make index composition changes, meaning we must delete or replace a stock. For the most part, the types of corporate actions that require index composition changes are as follows:
- Bankruptcies/Delistings: If a company files for bankruptcy or is delisted from an exchange, it is typically removed from our indexes immediately (with notice).
- Spinoffs: If a company splits or spins off a portion of its business to form one or more new companies, all of the companies involved in the spinoff are immediately included in our “benchmark” indexes (e.g. broad-based indexes such as the Dow Jones Total Stock Market Indexes), so long as they meet the index’s eligibility requirements. For most other indexes (for example, the blue-chip Dow Jones Titans Indexes), the larger or more liquid company (usually the original company) typically remains in the index.
Other corporate actions require us to make divisor adjustments. The divisor is a number whose sole job is to account for corporate actions. For example, in a typical market-cap weighted index, the index level is calculated by summing the market capitalizations of the individual securities, and dividing the result by a divisor. The divisor is adjusted up or down to cancel out the effects of corporate actions that would otherwise change the share capital of component stocks and ultimately the level of the index.
Q. What is the usual timeframe for changing index weightings based on an action? Are they immediate, based on regulatory review of a pending deal, etc.?
A. Typically, changes are announced with two business days notice. Clients can receive daily watchlists that provide a 10-business day forecast of upcoming corporate actions that impact a specific index. Final effective dates are based upon confirmation of all regulatory and shareholder approvals, as well as closing conditions.
Q. Is there a threshold point for these changes? For example, if a company does a 2% buyback versus 20%?
A. Changes to number of shares used in index calculations and free-float factors (which serve to reduce the number of shares used in index calculations to reflect those shares that are publicly traded) resulting from offerings or buybacks, are not accounted for unless they are 10% or greater. However, other actions, such as stock splits, rights offerings, special cash dividends or extraordinary events are not subject to thresholds.
Q. Which types of actions were most prevalent in 2011?
A. The most frequent corporate action in 2011 was stock splits, which is typically the case. The next most-frequent corporate actions last year were mergers, equity offerings and rights offerings.
Q. Are all corporate action processes covered by index methodologies?
A. By and large, yes. Rarely, an occasion arises that requires a revisiting of the methodologies. For example, prior to the 2008 market crisis we didn’t have express rules in certain blue-chip index methodologies outlining the removal process of companies due to bankruptcies/delistings, since such an event was so rare. Any revisions or exceptions to methodology take into account in-house evaluation of various treatment options.
