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A dozen of Canada’s biggest stocks are not part of the index, largely because of a ‘free-float’ adjustment on market caps.

A quick quiz: What is the S&P/TSX 60?

A. A stock index of the 60 most valuable companies in Canada.

B. A stock index of 60 of the most valuable companies in Canada.

Note the careful placement of the word "the." The correct answer is B, because the TSX 60 leaves out a number of Canada's biggest stocks. Other large companies are under-represented, compared to their stock market values. And this is completely intentional on the part of Standard & Poor's, which uses a very specific methodology to construct the TSX 60.

This, admittedly, seems at first to be a deadly boring topic. But there are real-world implications for Canadian investors: Funds that mimic the performance of the TSX 60 – and there are $20-billion invested in them, according to our read of Morningstar data – may not have exactly what their owners think they do. And investors in the companies that are under-represented are paying a penalty because the shares suffer from a lack of demand that a choice place in a major index might bring.

"Ideally the index should be as all-encompassing as it can be," says Robert Whaley, a finance professor at Tennessee's Vanderbilt University. (He is also a graduate of the University of Alberta, with his postgraduate work at University of Toronto.) "The hard-and-fast principle is that you're pretty much obliged to come up with as much market cap as you can possibly have."

Before we name some winners and losers, however, a short primer on index construction is necessary, unfortunately.

Most indexes use a measure of market capitalization to weight the companies they include. A more valuable company takes up a larger piece of the index.

But for the major TSX indexes, as well as many others, S&P adjusts pure market cap numbers. Instead of using the total value of the company, S&P calculates the value of a company's "free float," or the shares that are available to trade regularly.

Free float is best defined by what isn't included: Shares held by founding families, or by employees and executives, or by major strategic investors. Forty-four of the 230-plus companies in the S&P/TSX composite index have fewer than 75 per cent of their shares available in the free float.

By using free-float market cap rather than total market cap, S&P under-represents companies with heavy insider ownership in its indexes. Companies with a higher percentage of free float take up a larger share of the index than they would if overall market cap were the deciding factor.

In assembling the membership of the TSX 60, S&P takes another step. It wants the blend of industries in the 60 to resemble the broader composite index and not get too concentrated in one or two industries. To achieve that goal, S&P is willing to pass over a larger company in one of those industries and put a smaller company in a different industry in the 60. You might be able to guess which industries run the risk of over-representation.

"The Canadian market is dominated by energy, natural resources and finance, so it is not surprising that there are a number of large companies in these sectors," S&P spokesman David Guarino says. "However, if they were all included in the S&P/TSX 60, the sector balance in the 60 would be skewed too much to these sectors."

What is the practical import of this? Let's take sector balancing first. The five smallest companies in the TSX 60 right now have total market capitalizations between $3.5-billion and $5-billion, according to S&P's Capital IQ division, which supplied data for this article.

Companies like Great-West Lifeco Inc., Tourmaline Oil Corp., Fairfax Financial Holdings Ltd., and Inter Pipeline Ltd. all are more valuable (even with a free-float adjustment) and would be included if total market cap were only the determinant and industry allocation did not matter. They are not in the 60, though, because it already has its quota of energy and financial companies. (The Big Five Canadian banks currently take up almost 29 per cent of the TSX 60.)

A surprising victim: Alimentation Couche-Tard, a $16.5-billion market cap company, with free float of around $12-billion, remains on the outside of the TSX 60, looking in. When Loblaw Cos. Ltd. announced its deal to buy Shoppers Drug Mart, speculation that Couche-Tard would eventually take its place in the TSX 60 helped drive the shares up in the latter half of 2013. Instead, in late March, S&P chose to include the $14-billion market cap Pembina Pipeline Corp. (Mr. Guarino says S&P does not comment directly on why it selects or omits a particular company.)

S&P's use of free float cuts out other companies as well. Two examples are IGM Financial Inc. and Canadian Utilities Inc., which have market caps above $10-billion, but free floats of less than half that, and are therefore left out of the TSX 60. (The smallest companies in the TSX have free-float market caps of about $3.5-billion.)

It also helps underweight companies that make the cut. Thomson Reuters Corp., Husky Energy Inc. and Imperial Oil Ltd. each would represent 2 per cent to 3 per cent of the TSX 60 if S&P used total market capitalization. Heavy insider ownership means less than half the companies' shares are in the free float, however, and the float-adjusted weight for each is about 1 per cent or slightly less.

The math also works in reverse: Canada's widely held big banks, which take up a chunk of the TSX 60 from their market values alone, take on extra weight because so much more of their value is in the free float.

All told, the largest 60 public companies in Canada have market capitalizations above $8-billion; 12 of those don't make the TSX 60 through the application of S&P's rules, letting 12 other companies in.

In some ways, it's really the TSX 48 + 12.


Think the S&P/TSX 60 is Canada's 60 biggest companies? Think again …

  • Great-West Lifeco Inc., at about $29-billion in market capitalization, is the biggest Canadian public company not in the TSX 60.
  • TransAlta Corp., at $3.5-billion in market cap, is the smallest company in the TSX 60. But it ranks 110th in the S&P/TSX composite.
  • Twelve of the 60 biggest Canadian companies, by market cap, aren’t in the TSX 60, including Alimentation Couche-Tard Inc., Fairfax Financial Holdings Inc., and CI Financial Corp.
  • Canadian Tire Corp., with a market cap of $8.5-billion, is the 60th-largest company in the TSX composite. But there are 15 smaller companies behind it in the TSX 60.

David Milstead