Rebalancing and Reconstitution of an Index

Index managers must consider when the index should be rebalanced and when the security selection and weighting decisions should be re-examined.

Rebalancing

Rebalancing refers to adjusting the weights of the constituent securities in the index on a regularly scheduled basis – usually quarterly. Price-weighted indices are not rebalanced, and rebalancing is a minor concern for market capitalization indices as they mostly rebalance themselves.

Reconstitution

Reconstitution is the process of changing the constituent securities in an index. Since many indices base their portfolio allocation on a set of criteria, the securities that meet the criteria tend to change over time. Securities that no longer meet the criteria are excluded on the reconstitution date, and new securities are included. Oftentimes, the reconstitution will require further rebalancing as the turnover of securities changes the targeted allocations. Expected inclusion of certain securities in a widely-tracked index tends to drive prices up while expected exclusion tends to drive prices down in anticipation of future purchases or sales of related index funds.

Question

If a company in a market-capitalization index with a market capitalization of $15 billion at quarter-end will be replaced by a company with a market capitalization of $17.5 billion, what effect would the reconstitution have on the other companies within the index?

1. Allocations would stay the same.
2. Allocations to other companies would increase.
3. Allocations to other companies would decrease.

Solution

The correct answer is C.

Since the company to be added has a higher market capitalization than the one being kicked out of the index, the new company will be weighted more heavily thus reducing allocation to all other companies within the index.

A is incorrect. This is because the total weight allocated to the index constituents changes with the inclusion of a new company.

B is incorrect. This is because adding a higher market capitalization company means reducing the relative weight of existing companies in the index, not increasing it.