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Explain how indexes are rebalanced and reconstituted

CFA® Level I · Equity Investments · 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.

Which weighting scheme requires the least trading to maintain?

  1. Equal weightingWhy not: The highest-turnover common scheme: prices drift apart continuously, so the portfolio has to be traded back to equality.
  2. Market-capitalisation weighting — correct
  3. Fundamental weightingWhy not: Weights are reset to accounting measures that update on a reporting cycle, so the portfolio must be traded to each new target.

Capitalisation weights adjust automatically as prices change, so the portfolio stays at target without trading. The others drift away from target and must be traded back.

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.

The index calculation ignores the cost of those rebalancing trades. Index arithmetic assumes costless trading, so a scheme demanding high turnover carries a correspondingly larger gap between the index and the fund tracking it.

The hardest tier

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

  1. Because exchanges widen spreads on those datesWhy not: Exchanges do nothing of the kind; the spread widens, if at all, because of the one-sided demand itself.
  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

Others trade ahead of the predictable index demand. A fund obliged to hold exactly the index must buy additions and sell deletions on a known date, and that predictability is an exploitable position for anyone not so obliged.

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