ETF rebalancing and reconstitution

Oct 4th, 2021 | By | Category: ETF and Index News

By Varun Raju, Team Lead, Products, and Vaibhav Agarwal, Head of Products, Indxx.

Varun Raju, Team Lead, Products, and Vaibhav Agarwal, Head of Products, Indxx.

Varun Raju, Team Lead, Products, and Vaibhav Agarwal, Head of Products, Indxx.

Passive investing is a strategy structured on a diversified portfolio that seeks to mirror the performance of the market or a particular segment of the market in a rules-based manner. The most common manifestations of this strategy are through ETFs and index funds.

The portfolios of such funds are generally replications of the holdings in an index representing the target market/segment. The philosophy stems from empirical research illustrating that, in the long-term, passive strategies will deliver similar or better performance than their active equivalents.

What is reconstitution and rebalancing and why is it essential?

Financial markets are dynamic in nature. It is imperative to keep track of the evolving circumstances to identify situations that require an alteration to the portfolio composition. New information should be incorporated into the portfolio in a systematic manner to maintain an accurate reflection of the target market/segment. The processes through which these alterations are performed are called reconstitution and rebalancing. They are essential to preserve the representative nature of indexes and avoid risks.

Constituents of an index are selected through pre-determined parameters and allocated specific weights in a bid to accurately reflect its objective. Subsequent appreciations or depreciations in their value could cause them to veer off their original allocations leading to outsized influence from a single/group of constituent(s) on the portfolio. This phenomenon of portfolio drift can divert the index from tracking its target, inject volatility, and mitigate the benefits of diversification. It could also lead to regulatory concerns. Ex, regulated investment companies (RICs) in the US, which includes ETFs, cannot invest more than 25% of a fund’s total assets in the securities of a single issuer unless the investments are in government securities or other RICs. The reconstitution and rebalancing processes negate these risks while reaffirming the intended objective of the index.

Are reconstitution and rebalancing based on performance? What are other misconceptions?

While the terms are generally used interchangeably, reconstitution has much broader implication in that both portfolio constituents and weights are reset, whereas only the weights are reset in a typical rebalancing process; in both cases to conform to the stated index objective. They are called into action based on the rules governing an index, regardless of index performance. In keeping with the passive investing ideology, their primary purpose is to enable accurate reflection rather than generate performance. They are implementations of the pre-determined parameters that guide constituent selection and exposure.

The turnover caused by reconstitution/rebalancing often misleads investors to judge the deleted securities as bad and new additions as fundamentally good. Such decisions, based purely on index membership, are biased and inadequate to influence investment decisions.

What is the reconstitution effect and how does it affect the portfolio?

The periodicity and transparency of reconstitutions opens a window for investors to speculate on upcoming changes in indexes. Index providers announce in advance the constituent changes in their portfolios. Funds tracking such indexes are obligated to conduct their transactions on the reconstitution date to minimize tracking error. This situation is leveraged by market participants like hedge funds, who take large positions in securities preceding the reconstitution date and close these on the reconstitution date. This spree of buying and selling can cause the funds tracking such indexes to buy (sell) incoming (exiting) constituents at slightly higher (lower) prices. Termed the ‘reconstitution effect,’ this process can have an adverse impact on index performance. The actions of the outside investors also, however, leads to sufficient liquidity during reconstitutions, which is essential for fund managers.

Recent studies indicate a decline in the expected costs of index reconstitution, likely due to advances in index methodologies and exchange technology. Nonetheless, these costs must be considered while deciding the scale and frequency of reconstitutions/rebalancings.

Other nuances behind reconstitution and rebalancing

Index providers strive for a balance between accurate representation and costs while determining the frequency of reconstitutions and rebalancings. Transactions costs associated with turnover could be incurred for statistically insignificant performance shifts. Indices employ ‘buffer rules’ to limit such turnover.  These usually offer some leeway to current index constituents on the thresholds that direct security selection, thereby reducing the probability of higher turnover in subsequent reconstitutions without compromising on the integrity of the index.

There are other technicalities too peppered into index development that are ever evolving. For instance, the Indxx MicroSectors North American Cannabis Index follows a 5-day rolling reconstitution period. Effecting changes over multiple days (‘rolling reconstitution’) against the usual 1-day reconstitution can lead to lower liquidity premiums and tracking errors.

The unrelenting growth of passive investing, owing to its ease and low costs, has further galvanized index providers and fund managers to discover innovative solutions and reduce market inefficiencies. The processes of reconstitution and rebalancing remain two crucial ingredients in achieving the perfect mix.

(The views expressed here are those of the authors and do not necessarily reflect those of ETF Strategy.)

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