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, which creates turnover.

Equal-weighted and fundamental factor-weighted indexes are rebalanced on a schedule, often quarterly. Price-weighted and market-cap-weighted indexes rebalance automatically: their weights move with prices, so price moves alone need no trades. They still need divisor changes for corporate actions such as splits, new issues and buybacks, and they are reconstituted. In the three-stock table, for example, Y’s cap weight moves on its own from 46.3% to 42.3%, and no one trades.

Rebalancing an equal-weighted index is counter-trend trading : it sells recent winners and buys recent losers. A fundamental index does the same relative to its fundamentals: it trims shares whose price has risen faster than their earnings or sales.

Take the equal-weighted index from lesson 3. After one period its holdings are no longer equal in value: X is worth 90 × 88 = 7,920 (33.7%), Y 288 × 24 = 6,912 (29.4%) and Z 160 × 54 = 8,640 (36.8%). The total is 23,472, an index of 1,086.67 with a divisor of 21.6.

Stock	Weight after one period	Weight to restore	Trade
X	33.7%	33.3%	trim by 0.4 points = 1.09 shares
Y	29.4%	33.3%	buy 3.9 points = 38 shares
Z	36.8%	33.3%	sell 3.5 points = 15.11 shares

Buying 38 Y shares at 24 costs 912, which is 3.9% of 23,472. That is a one-way turnover of 3.9%, and every trade costs money for anyone replicating the index.

How many shares does a rebalancing trade?

Use it

Each holding should be worth the aggregate value divided by the number of constituents. Divide that target by the share’s current price to find the number of shares to hold.

$$n_i^{new} = \frac{V_{aggregate} \div N}{P_i}$$

Fractional shares like 88.91 are common in rebalancing; a fund tracking the index must round them. A total return version starts from the value with reinvested dividends (23,796 here) and works back the same way.

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 changes membership, not just weights.

Index managementboth create turnover and trading costs

• Rebalancing Memorize reset the weights of the existing constituents
  • Equal-weighted and fundamental on a schedule, often quarterly
  • Price- and cap-weighted rebalance automatically with prices; divisor changes for corporate actions
• Reconstitution Memorize change which securities are in the index
  • Add securities that now meet the rules
  • Remove no longer qualify, bankrupt, delisted, merged
  • Adjust divisor, sometimes past values

Know the idea

The process has three steps. (1) The provider ranks securities, usually by market value, and tests them against the inclusion rules. (2) It announces the preliminary changes a few weeks ahead, then the final list. (3) It implements the changes at the close of the reconstitution date. Removals include securities that no longer qualify and those hit by bankruptcy, delisting or a merger. The provider may recalculate past values, and it adjusts the divisor so the index does not jump on the day.

Reconstitutionthree steps

• Rank and test Know the idea rank securities, usually by market value, and test them against the inclusion rules
• Announce Know the idea preliminary changes a few weeks ahead, then the final list
• Implement Know the idea at the close of the reconstitution date

Two examples. To limit needless turnover, some providers use banding : Russell, for instance, moves an existing member between its large- and small-cap indexes only if its market value is more than 5% away from the central value of the breakpoint; the Russell 2000 is reconstituted once a year. The FTSE 100 is reviewed every quarter (March, June, September, December) by full market value: a member that ranks 111th or lower leaves, and a company outside the index that rises to 90th or higher joins.

Reconstitution creates turnover and cost for index funds. It can also move prices. Funds and derivatives built on an index, such as an exchange-traded fund (ETF) that tracks the S&P 500 or futures on an index, must follow every rebalancing and reconstitution, which is why these dates move prices. 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 measures of how a market performed and are still the benchmark that portfolios are judged against. They now also make passive investing possible: an index fund or exchange-traded fund aims to replicate an index at low cost, while active investing tries to beat a benchmark through security selection and timing. The index is the fund’s blueprint. Providers also build a custom index for particular objectives and risk levels, which blends passive tracking with active choices.

Custom indexesrules-based, built for one objective

• Market factor Know the idea momentum, value
• Thematic Know the idea for example clean energy
• Income-oriented Know the idea high dividend yield shares, bonds
• Risk-weighted Know the idea for example minimum variance
• Active strategy Know the idea shifts with economic, credit and market cycles

A benchmark is only fair if it matches what the manager can buy: a manager who weights holdings by earnings should be compared with an earnings-weighted index. 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.

Types of equity indexes are covered in Equities and types of bond indexes in Fixed Income.