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Explain how indexes are rebalanced and reconstituted

CFA® Level I · Equities · Equity Issuance and Trading · EQ.3.c

The idea

Rebalancing resets constituent weights to the scheme the index specifies, and reconstitution changes which securities are members at all. A market-capitalisation-weighted index rebalances itself as prices move and needs trading only when shares outstanding change, which is why it has the lowest turnover. Equal-weighted and fundamentally weighted indexes must be traded back to target periodically, so their reported returns overstate what an investor nets after costs. Reconstitution dates are known in advance and are traded ahead of by others, so index funds face predictable adverse price movement around them.

A practice question

From the question bank, with the reason each wrong option is wrong.

What does reconstitution change?

  1. Which securities are members of the index - correct
  2. The weights of existing members onlyWhy not: That is rebalancing. Reconstitution is the step that adds and drops names.
  3. The index's base dateWhy not: The base date is fixed once at launch and survives every membership change.

Reconstitution is the periodic review in which securities are added to, or removed from, an index. For example, a company may join when it grows past a size limit, or leave when it is bought. It changes the list of members. Rebalancing is different: it only resets the weights of the members already in the index. A new company joining is a change of membership, so it is reconstitution. The base date, the starting date for the index level, is fixed at launch and does not change.

A harder one

Why does an equal-weighted index's reported return overstate an investor's achievable return more than a capitalisation-weighted one's?

  1. Because equal weighting requires frequent trades - correct
  2. Because equal-weighted indexes exclude dividendsWhy not: Dividend treatment is a separate choice and either scheme can be published as a price or a total return index.
  3. Because equal-weighted indexes hold fewer securitiesWhy not: The two versions of an index hold the same names. What differs is how much of each and how often that has to be corrected.

An index return is worked out as if adjusting the portfolio costs nothing. A real fund has to pay trading costs. Equal weighting means each share has weight = 1 / number of shares, for example 1/100 = 1.0% each. When a share doubles, its weight is now well above 1.0%, so the fund must sell some of it and buy the losers. This happens all the time, so costs build up. Capitalisation weights adjust by themselves as prices move, so very little trading is needed and the gap is smaller.

The hardest tier

Why do index funds often experience adverse prices around reconstitution dates?

  1. Because exchanges widen spreads on those datesWhy not: Spreads are set by market conditions, not by the exchange on particular dates; any widening comes from index funds all wanting to trade in the same direction at the same time.
  2. Because reconstitution is always a surpriseWhy not: The reverse is the problem. The changes are published ahead of time, and that predictability is what others trade against.
  3. Because the changes are announced in advance - correct

Reconstitution means the index changes its list of members. These changes are usually announced before they take effect. Other traders then know that index funds must buy the new additions and sell the removed shares on the effective date. They buy the additions and sell the removals first, which moves prices against the funds. For example, a share announced as joining an index often rises before the date, so funds buying on the day pay more. The fund must match the index exactly and cannot wait, which is what others take advantage of.

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