(Re)constitutional Conventions: Stock Indexes and Rebalancing

Understand the timing and mechanics of index rebalancing and index reconstitution.

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Change is a part of life that you either fear or embrace, but you can’t deny it. In the stock market, micro change happens daily to individual stocks with every new tick. On a macro level, it happens when a major index goes through a “rebalancing.” Understanding the mechanics of an index rebalance—and how it can affect your portfolio—can help to make sure you don’t get caught off guard when change comes.

An index is created by selecting a group of stocks and then applying either a direct (simple) or indirect (complex) calculation to determine the weighting of each stock. An example of a direct calculation would be to add together the share prices of all the included stocks and use that total as the index price. An indirect calculation could involve adding all the share prices, dividing by the number of stocks, and then multiplying by their individual average trading turnover, market cap, or any other variable.

Most indexes are calculated using an indirect method, such as the Dow Jones Industrial Average ($DJI), which is a price-weighted index. The index value is calculated by Dow Jones using a proprietary methodology, which includes adding the share prices of the 30 component stocks and dividing by the “Dow Divisor.” The resulting index value is published daily in The Wall Street Journal.

Why Do Indexes Need to Be Rebalanced?

Markets are continually changing. Over the course of a year, companies are listed or delisted, existing firms are acquired or merge with other companies, and small companies can grow to become large companies (or vice versa). Without regular rebalancing, an index can become overly weighted toward a small group of stocks or a particular sector.

There are no rules governing the frequency of index rebalancing, but many experts suggest it should be done annually. One well-known index, the Russell 2000 (RUT), does a complete top-to-bottom rebalance—which they refer to as a “reconstitution”—every June to more accurately reflect the current equity markets.

To understand the need for periodic rebalancing, consider the case of a company like Amazon (AMZN). Amazon currently has a market capitalization of over $450 billion and is one of the biggest companies in the world. But at one time it was part of the Russell 2000, an index that tracks small-cap stocks. As the company grew, rebalancing took the stock out of that index and added it to the Russell 1000 Index, which is a large-cap index.

How Does This Affect Individual Stocks?

With the rise of ETFs and index investing, there’s been a greater focus on the addition and subtraction of stocks from indexes, especially from the three most widely followed: the Dow Jones Industrial Average ($DJI), S&P 500 (SPX), and Nasdaq 100 (NDX). This is because many institutional investors attempt to mirror the performance of these indexes by buying the same stocks that comprise them, and some funds are even required by their charter or offering prospectus to hold the same stocks.

So when a stock is added to a widely followed index, millions, and sometimes billions, of purchase dollars flow into that stock, driving its price higher. Conversely, when a stock is dropped from an index, it is often sold by institutional players, causing it to drop in price. However, these price fluctuations are usually short-lived, and some studies indicate that just being a part of an index in and of itself has no permanent effect on a stock’s value.

Here’s one way of looking at it: When a stock is added to an index, it’s often done based on a sustained increase in earnings, appreciation in market value, and positive price momentum. Because of those factors, a stock may exhibit better performance following its addition to an index. But if those factors change, a stock can underperform, even if it is still part of the index.

An interesting corollary is that a stock can be dropped from an index, not because it’s been underperforming, but because the index allows only a set number of stocks, and room needs to be made for a new one to be added. In this case, a buying opportunity might present itself when a stock whose fundamentals remain strong dips on the initial selling after being dropped from the index.

Rebalancing is a simple fact of life in the world of indexes, so it’s good to understand the timing and dynamics of rebalancing. 

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