Porsche, the index and a fundamental flaw

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We have all read and heard about the short squeeze in Volkswagen caused by Porsche, some even felt the pain. I think Porsche did a great job, considering that its methods were accepted by the relevant regulators. Nevertheless, it would be a cleaner solution to spin-off the options business from the car business and make a hedge fund out of it.

What is really disturbing about the whole story is the fact that Volkswagen-shares drove several stock indices - and as a consequence index-funds - crazy. And, although the press is of another opinion, this was not just particular to Germany and its blue chip index DAX. The question is whether market capitalization indices are not fundamentally flawed by not taking into account stock held outside the free float (for a description of the DAX see here). In a situation as with Volkswagen, where only a little less than 6% of the shares were available for trade, supply and demand over such a small portion of the capital determines the market capitalization. I agree that VW is an extreme example, but in an up-market where buy and hold strategies prevail, the free float logically also will be lower, which probably might lead to similar phenomena, i.e. bubbles, although they might not be so obvious. Cutting the exposure of an index to a certain limit of a specific stock does not remedy the illness: the price of such stock is still determined by very few market players and therefore is a distorted reality. One has to distinguish between the market price of a stock, which is relevant for persons that want to actually trade such stock, and the value of a stock. An index should not be prisoner of the market price without taking into account stock outside the free float. Not-selling is also a view worth considering, especially if one or more investors own a substantial part of a company's capital. The lower the free float the less the market price should influence the index and the more the views of holders of locked-in shares should be taken into account. An index build with such a dynamic rule would mirror far better economic realities as it would take into account the views of actual buyers and sellers on the share price as well as of holders of locked-in shares.

By the way: the figures in the media of losses in hedge funds of up to US$30bn because of the short squeeze in VW seem far overreaching. Actual losses seem to be more in the area of US$4bn, which is still painful but - taken as a single event - not a killer-event (see FT).

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