Index managers must consider when the index should be rebalanced and when the security selection and weighting decisions should be re-examined.
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 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. On the reconstitution date, securities that no longer meet the criteria are excluded 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.
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?
A. Allocations to other companies would decrease
B. Allocations would stay the same
C. Allocations to other companies would increase
The correct answer is A.
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.
Reading 45 LOS 45f:
Describe rebalancing and reconstitution of an index