CFAI text states this: “Float weighting is generally regarded as today’s gold standard for indexing portfolios because it facilitates the minimization of tracking risk and portfolio turnover…”
I don’t understand how it minimizes the tracking risk. Please explain.
float weighted index adjusts for # of shares actually available for purchase.
since the actual # of shares purchased (on the portfolio) and the # of shares on the float weighted index are both on the same base (# of shares available for purchase) the float weighted index would be a more accurate representation. (and hence say a portfolio buying 5% of a sector, compared against 6% on the benchmark index (which is float weighted) would show a tracking error of 1% squared - which is more accurate than if the benchmark index were not float weighted.
Imagine a company has a low float , i.e. most of its shares are not traded on the stock exchange.Prices are set at the margin by only a few investors ,and probably would not reflect its fundamental pricing . If this stock has a large capitalization , its market value movements , which can diverge substantially from the index components , would cause headaches for a passive manager that is trying to replicate the index . This manager wants to track the price of the stock adequately , but is unable to buy them as most of the stock is not traded.
That is why the index providers do not like plain value weighting : their licensees would much rather prefer a float weighted index where the weights are dependent on the float available to trade
Thanks guys. I understand it now.