Why index reconstitution matters to your portfolio

To be consistently representative of the markets they track, indexes must change—or be reconstituted—to keep pace with change in the market. While investors expect their index-tracking investments to replicate the market’s performance, the downside impact of reconstitution can ripple through their portfolios in the form of high trading costs, tax implications, and shifting market exposures.

The history of market indexes is really a history of market measurement. In the days before indexes existed, stock markets were relatively chaotic places whose contours were difficult to define. Investing in stocks was almost exclusively accomplished through bankers, whose industry knowledge was anything but publicly available.

One of the first landmarks in the history of index construction was an attempt to democratize financial information: a three-volume “history” written by a financial analyst, Henry Varnum Poor, eponymous father of Standard & Poor’s. Published in 1860, Poor’s History of the Railroads and Canals of the United States of America offered a new paradigm for financial research by systematizing and broadly distributing several years’ worth of financial information gleaned from a single market segment. Where formerly there was no comprehensive, accessible view, Poor sought to fill the gap with:

        “a statement of the organization and condition of all our companies, and at the same time […] a history of their operations from year to year, which would necessarily reflect the character of their management, the extent and value of their traffic.” 

Of course, a comprehensive statement about railroads and canals—the arteries of the U.S. economy in the latter half of the 19th century—would need to be written and rewritten in annual supplements to the original 1860 publication. In the abstract, rewriting a descriptive statement about the market is what indexes must constantly do in order to keep pace with market change.

The process of making regular changes to an index is called reconstitution or rebalancing. Many of the most popular and widely followed indexes today—including the Dow Jones Industrial Average, the Russell indexes, and the global series of S&P indexes—reconstitute, revising their list of constituents, on a quarterly or annual basis.

Sometimes, this process nets relatively few differences; other times, the changes can be substantial. For example, in its June 2017 reconstitution, the Russell 2000 Index—a bellwether for small-cap U.S. stocks—experienced the following changes¹:

• 228 companies were added to the index
• 137 companies left the index
• 42 companies entered the index by moving down from the large-cap Russell 1000 Index
• 115 companies entered the index by moving up from the Russell Microcap Index
• 31 companies exited the index by moving up into the Russell 1000 Index
• 26 companies left the Russell Index universe altogether

For a passive portfolio tied to the Russell 2000 Index, the imperative to buy 228 names and sell 137 names amounts to a significant and immediate trading requirement. Moreover, the 2017 reconstitution of the Russell 2000 Index saw the smallest component become 8% larger in market capitalization relative to the smallest component in the prior year, while the largest component grew by 14% relative to the previous year’s largest component. Meanwhile, due to performance effects, the total market capitalization of the index increased 21% relative to the prior year. In the wake of this particular reconstitution, index-tracking investors’ small-cap exposure would have become larger—whether they liked it or not.

The movement of securities in and out of indexes can have important implications for the portfolios that track them, which in turn has implications for investment accounts, retirement savings, pension plans, and sovereign wealth funds the world over. For individuals invested in a passively managed mutual fund or exchange-traded fund (ETF), their portfolios typically must buy the index additions and sell the deletions as soon as possible so that the tracking error of their fund remains low.

The consequential flurry of trading that follows reconstitution is highly visible and well anticipated in the market. Consider what happens, for example, when an index such as the S&P 500 announces that it's about to add or delete constituents. The public announcement of the coming changes leads to opportunistic and speculative positioning by some investors. And for the innumerable ETFs and funds that attempt to replicate this index as closely as possible, the day on which the changes are made will see an avalanche of forced trading.

When reconstitution creates the imperative to buy or to sell, individual managers have very little room to maneuver in terms of price negotiation. As a result, index funds and market-cap-weighted ETFs are forced to buy high and sell low. Furthermore, the trading cost due to commissions and other expenses that stem from all of this activity is passed on to fund shareholders, and it’s not reflected in a fund’s expense ratio.

Not all indexes are subject to the same reconstitution performance drag. For example, factor-based indexes may be defined in relation to parent indexes, such as the S&P 500 Index or the Russell 2000 Index, and include rules allowing them to delay trading following parent index reconstitution. Some industry research has shown that a simple delay in trading names that have just entered or departed an index can carry a substantial cost benefit for a portfolio over time.

The same may be said of investment products, such as smart beta ETFs, that are designed to capture the performance of systematic exposures to certain stock characteristics. The focus on characteristics rather than specific stocks provides a degree of flexibility that traditional indexes simply don't have. For smart beta portfolios, reconstitution can pose less of a performance obstacle—and even become a relative-performance opportunity.

Learn more about multifactor ETF investing here.

1 FTSE Russell, June 2018.