Rebalancing, reconstitution and what indexes are used for

What is rebalancing?

rebalancing means adjusting the weights of the securities already in the index so that they match the weighting rule. Weights drift as prices move. The provider resets them on set rebalancing dates, usually quarterly, which creates turnover.

Take the equal-weighted index from lesson 2. After one period its weights are no longer equal.

Stock	Weight after one period	Weight to restore	Trade
X	33.7%	33.3%	trim by 0.4 points
Y	29.4%	33.3%	buy 3.9 points
Z	36.8%	33.3%	sell 3.5 points

Rebalancing sells recent winners and buys recent losers. Moving 3.9 points of the index is a one-way turnover of 3.9%, and every trade costs money for anyone replicating the index.

The need differs by method. Equal-weighted and fundamental indexes must rebalance, because their weights depend on a rule that prices disturb. Price-weighted indexes are not rebalanced, since the weights are the prices. Market-cap-weighted indexes largely rebalance themselves. In the same table, Y’s cap weight moves on its own from 46.3% to 42.3%, and no one trades. They change only for corporate actions such as new share issues, buybacks, mergers and changes in float.

Exam tip ”Which index needs the most rebalancing?” Equal-weighted. A cap-weighted index lets the market do the rebalancing.

What is reconstitution?

reconstitution changes the securities in the index. On the reconstitution date the provider re-applies the selection rules: it adds new securities that qualify and removes those that no longer do, because they became too small, merged, delisted or changed style. The weighting rule is then applied again to the new list. Reconstitution is part of the rebalancing cycle, but it changes membership, not just weights.

Index managementboth create turnover

• Rebalancing Memorize reset the weights of the existing constituents
  • Equal-weighted and fundamental rebalance often, usually quarterly
  • Market-cap-weighted largely rebalances itself
  • Price-weighted weights are the prices; not rebalanced
• Reconstitution Memorize change which securities are in the index
  • Add new securities that meet the rules
  • Remove securities that no longer qualify, merge or delist

Reconstitution creates turnover and cost for index funds. It can also move prices. Funds that track a widely used index must buy the shares being added and sell the ones being removed, so investors who expect the changes buy the likely additions early and sell the likely deletions, and the prices move before the change takes effect. Frequent or predictable reconstitution gives more room for this.

Go deeper The index effect, and why it has shrunk

Shares often rise when they are announced as additions and fall when they are dropped, partly because index funds must trade them and partly because inclusion draws attention. Traders learned to anticipate this, so the move now often happens before the announcement, and some of it reverses afterwards. Providers have responded by announcing changes in advance and phasing them in. For the exam, know the direction (additions up, deletions down) and the cause (forced buying and selling by funds).

What are indexes used for?

Indexes began as a way to see how a market did on a given day. With modern portfolio theory they gained five main uses.

Use	Example
Gauge of market sentiment	“the market fell 2% today”
Proxy for returns, systematic risk and risk-adjusted performance	beta against a broad cap-weighted index
Proxy for an asset class in asset allocation	a global bond index stands for “bonds” in an optimizer
Benchmark for an active manager	a small-cap growth fund is compared with a small-cap growth index
Model portfolio for investment products	index funds and exchange-traded funds (ETFs) replicate it

What indexes are used for

• Gauge of market sentiment Use it how the market did today
• Proxy for returns, systematic risk and risk-adjusted performance Use it beta and alpha need a market index
• Proxy for an asset class Use it inputs to asset allocation models
• Benchmark for active managers Memorize must match the manager style and universe
• Model portfolio for investment products Use it index funds and exchange-traded funds (ETFs) replicate it

Return and risk proxy. In the capital asset pricing model beta measures a security’s systematic risk relative to the whole market. A broad index is the systematic risk proxy , standing in for the market portfolio. The same index lets you build a passive alternative with the same beta: if an active portfolio has a beta of 0.95 against a world index, hold 95% in an index fund and 5% in cash. Alpha is the active portfolio’s return minus the passive portfolio’s return. It reflects skill (or the lack of it), costs and fees.

$$\alpha = R_p - \left[\beta R_m + (1 - \beta) R_f\right]$$

Benchmark. A benchmark is the index against which an active manager is judged. It should match the manager’s style and universe. Suppose a small-cap manager returned 9%, a small-cap index 12% and a broad market index 7%. Against the broad index the manager looks 2 points ahead. Against the right yardstick, the small-cap index, the manager is 3 points behind. The wrong benchmark can make a lagging manager look skilled, or a skilled one look weak.

Model portfolio. A model portfolio is a portfolio that investment products copy. Index mutual funds and exchange-traded funds replicate an index. Providers now create narrow indexes specifically so that a fund can be built on them.

Go deeper Benchmark misfit and performance appraisal

If the benchmark does not match what the manager buys, the difference in returns mixes skill with the mismatch. The Portfolio Management topic returns to this when it evaluates performance, and the Global Investment Performance Standards (GIPS) in Ethics expect a firm to use a benchmark that is appropriate for the strategy and to say what it is.