Register For Our Mailing List

Register to receive our free weekly newsletter including editorials.

Home / 477

What happens when an index is rebalanced?

When it comes to the topic of rebalancing, most investors tend to think about portfolio rebalancing, that is, the buying and selling of shares in a specific asset class to realign a portfolio’s asset allocation back to an investor’s risk tolerance and goals. It is largely a risk management exercise that occurs either periodically or when a certain threshold has been met.

But for asset managers that manage index funds, the term 'rebalancing' more specifically as it relates to index rebalances, has a slightly different meaning. How does index rebalancing work?

It all starts with the benchmark index

Market indices are designed to represent and measure the performance of securities in a specific market, asset class, sector or investment strategy. Indices like the S&P/ASX300 are financial calculations, based on a grouping of financial instruments, and therefore are not directly investible. Rather, investors seeking exposure to an index often invest through index-tracking mutual funds and exchange traded funds (ETFs), which are generally designed to track the performance of a specified index as closely as possible.

So what is an index rebalance?

An index rebalance occurs when the composition of an index changes. This process most notably occurs at regular periods throughout the year. Index rebalances are publicised events and the dates are typically known in advance. The S&P/ASX 300 for instance - an index that tracks the performance of the 300 largest ASX shares by market capitalisation - issues notifications for rebalances each March, June, September and December. The notification outlines the new composition of the index and also a specific date when these changes are to occur.

As a result, index fund managers must reconfigure portfolio holdings to match the rebalanced index in order to continue to achieve their index-tracking objective.

Why is an index rebalance necessary?

Index providers, such as S&P Dow Jones/ASX, FTSE Russell, MSCI and Morningstar, are responsible for building and maintaining a wide variety of indexes. These index providers are also responsible for ensuring that the composition of an index adequately reflects its stated methodology or objective.

This is done partially through regular updates, or 'rebalances', which are changes to an index’s holdings and holding weights. An index that remains static for a prolonged period of time would likely drift and not accurately reflect the target market that it is attempting to represent. For example, in the ASX 300, a merger or bankruptcy could cause index constituents to temporarily drop below 300 but at rebalance time, additions would top the benchmark back up to 300 names.

What happens during an index rebalance?

Using the S&P/ASX 300 as an example, the March and September rebalances focus on additions and deletions of companies to the index, while the objective of the June and December rebalances is primarily to ensure that the weightings of each company in the index is accurate against the benchmark.

In the S&P/ASX 300 September rebalance announcement, 16 companies were added to the index, while 12 companies were removed. This means asset managers like Vanguard with funds (eg the Vanguard Australian Shares Fund and ETF) that track the ASX 300, had to buy shares of the 16 companies that have made it into the ASX 300 and sell down shares of the 12 companies that have dropped out of the ASX 300.

Keeping cost low

Indexing is a simple concept and easily understood, which is part of its beauty. But like any product or service that is deceptively simple on the surface, delivering what is promised without fanfare, is in reality, a complicated series of steps that must be executed with precision.

Think for a moment how benchmark indices like the ASX 300 are calculated. These calculations are done without taking into account the frictional costs of transacting in the real world, such as commissions, ticket charges, custody fees and market impact cost, just to name a few. It is easy to replicate an index perfectly but that comes with additional frictional costs at the expense of the investor.

Producing a portfolio whose performance replicates the index while minimising the deadweight costs and frictions that could lead to negative tracking error requires a level of heavy investment activity and precision. A good index manager demonstrates their value best during an index rebalance, by deploying sophistication in the complex investment management process and executing for the benefit of investors.

Not easy to speculate ahead of index rebalancing

For some investors, scheduled rebalances could seem like easy opportunities to make a quick profit, by buying or selling securities named in the index rebalance announcement. There might be an expectation that companies added to the index could deliver positive excess returns, and vice versa for those deleted from an index.

However, given the complex and noisy nature of this trading ecosystem, with players on all sides entering and exiting the market at different times and responding to evolving incentives, the profitability of this trade after costs is questionable.

Vanguard would caution everyday investors against engaging in this behaviour without understanding the risks involved, as this is less like investing and more like speculation or market timing.

Rather than chase after that potential lucky needle in a haystack trade, we urge investors to consider buying the whole haystack (ie a broadly diversified index fund) and invest for the long term. Ultimately, buying a broadly-diversified fund can probably help to achieve investment goals with less risk.

 

Duncan Burns is Head of Investments for Asia-Pacific at Vanguard Australia, a sponsor of Firstlinks. This article is for general information purposes only and does not consider the circumstances of any individual.

For more articles and papers from Vanguard Investments Australia, please click here.

 

5 Comments
Nattu Durai
October 08, 2022

A query regarding capital gain distribution to investors of NDQ vs QQQ.

NDQ is ASX based ETF. QQQ is US based but both track NASDAQ 100 index and perofrmance returns are same.

I invested in NDQ and getting capital gain distrubutions for which i am paying capital gain tax yearly. But i heard QQQ doesn't distribute capital gains to investors so the investors doesn't need to pay CGT yearly.

if this is correct Is it better to invest in QQQ to avoid CGT?

Angus McLeod
October 07, 2022

The rebalance trade is most certainly an opportunity for speculators. With so much money in indexed investments the weight of trading for inclusions most definitely raises their price and the dumping of exclusions pushes them down. There is ample event study research in this area.

Stock brokers' proprietary trading desks capitalise on this and see the index change point as an easy liquidity event to exit their positions. Some brokers even offer guaranteed closing prices to passive funds on the back of their speculative trading. The index funds, and I'm sure Vanguard is among them, must trade earlier than the change date due to the market impact of their trading volume.

Therefore there's a perfect market for a willing speculator with appropriate risk appetite to take advantage of these market events.

Martin
September 30, 2022

In the USA, ETFs avoid capital gains taxes when they rebalance by using heartbeat trades and an old tax law from President Nixon from 1969.

Can Australian ETFs avoid Australian capital gains tax when they rebalance like US ETFs, or do Australian ETFs suffer a performance drag every time they rebalance due to the capital gains tax?

Martin
September 28, 2022

Dean, I think the vast majority of investors in index funds do so for the overall simplicity, and because over 80%% of actively manged funds perform below the index. Having said that I would be interested in understanding the materiality of the issues you raised

Dean Ward
September 28, 2022

From a purely statistical perspective, the rebalancing of the major indexes, raises issues. In theory, new entrants should reflect price and demand increased and removals the opposite. This is not due to changes to fundamentals, but the mere fact of being included/excluded. In addition, the index eg ASX300 is not standardised overtime due to its "constituent changes". Compare it to say the CPI regiment - would the CPI be a valid measure if the items comprising it were being changed over time, recognising allowed weighting and heuristic adjustments? For example, if is set my performance benchmark as the ASX300 as at 2015 and wanted to track its performance/my portfolio performance, using the current ASX300, this is not valid, yet its the standard practice. To create a "normalised" index is difficult to create. The other issue, is the inclusion/removal of new companies. The ASX300 does not reflect the largest companies by capitalisation and reflects elements of vogue for example increasing ASX300 companies in perceived growth sectors such as lithium, REE, IT. By definition, their inclusion forces exclusions. So what is the intent and principles of the ASX300? S&P do have their standards, however should these be defining the index or should more rigour and debate be occurring, given the materiality. For example, should the inclusion and exclusion be based on transparent rules outside the control of S&P and other?

 

Leave a Comment:

     

RELATED ARTICLES

There's nothing sleepy about Rip Van Winkle indexing

Track if your fund manager is taking the best shot

banner

Most viewed in recent weeks

16 ASX stocks to buy and hold forever

In his recent shareholder letter, Warren Buffett mentions several stocks he expects Berkshire Hathaway will own indefinitely, including Occidental Petroleum. We look at ASX stocks that investors could buy and hold forever.

The best strategy to build income for life

Owning quality, dividend-producing industrial shares is key to building a decent income stream. Here is an update on the long-term performance of industrial stocks against indices, listed property, and term deposits.

Are more taxes on super on the cards?

The Government's broken promise on tax cuts has prompted speculation about other promises that it may consider breaking. It's widely believed that super is lightly taxed and a prime candidate for special attention.

Lessons from the battery metals bust

The crash in lithium and nickel prices has left companies scrambling to cut production, billionaires red-faced, and investors wondering how a ‘sure thing’ went so wrong. There are plenty of lessons for everyone.

Welcome to Firstlinks Edition 545 with weekend update

It’s troubling that practical skills like investing aren’t taught at schools as it leaves our children ill-equipped to build wealth, and more vulnerable to bad advice. Here are some suggestions to address the issue.

  • 1 February 2024

For the younger generation, we need to get real on tax

The distortions in our tax system have been ignored for too long, and we're now paying the price. It's time Australia got real and addressed the problems to prevent an even greater intergenerational tragedy.

Latest Updates

Shares

16 ASX stocks to buy and hold forever

In his recent shareholder letter, Warren Buffett mentions several stocks he expects Berkshire Hathaway will own indefinitely, including Occidental Petroleum. We look at ASX stocks that investors could buy and hold forever.

Investment strategies

Clime time: 10 charts on the outlook for major asset classes

The charts reveal that interest rates can't rise much further as Australian mortgage holders are under stress, bank dividends look solid, and the bond market is in flux because yields are being manipulated.

Strategy

Phasing out cheques, and what will happen to cash?

Cheques and bank service, or the lack of, were major topics when I addressed a seniors’ group recently. The word had got out that the government was phasing out cheques, and many in the audience were feeling abandoned.

Retirement

What financial risks do retirees face?

Treasury's consultation into the retirement phase of superannuation is generating a lot of interest. This submission to the consultation outlines the key financial risks to an individual’s standard of living in retirement.

Shares

Recession surprise may be in store for the US stock market

Markets are partying like it's 1999, but history suggests that US earnings and economic growth are vulnerable following an interest rate tightening cycle. Investors should prepare their portfolios accordingly.

Investment strategies

3 under the radar investment opportunities

The Magnificent Seven are hogging the headlines, yet there are plenty of growth opportunities elsewhere, at a fraction of the cost. Here are three stock ideas riding key areas of structural and cyclical change.

Shares

Why a quant approach can thrive in the age of passive investing

The rise of passive investing is unlikely to derail the value of quantitative strategies. Passive investing hasn’t eradicated the irrationality of crowds, leaving pockets of opportunity to outperform indices.

Sponsors

Alliances

© 2024 Morningstar, Inc. All rights reserved.

Disclaimer
The data, research and opinions provided here are for information purposes; are not an offer to buy or sell a security; and are not warranted to be correct, complete or accurate. Morningstar, its affiliates, and third-party content providers are not responsible for any investment decisions, damages or losses resulting from, or related to, the data and analyses or their use. To the extent any content is general advice, it has been prepared for clients of Morningstar Australasia Pty Ltd (ABN: 95 090 665 544, AFSL: 240892), without reference to your financial objectives, situation or needs. For more information refer to our Financial Services Guide. You should consider the advice in light of these matters and if applicable, the relevant Product Disclosure Statement before making any decision to invest. Past performance does not necessarily indicate a financial product’s future performance. To obtain advice tailored to your situation, contact a professional financial adviser. Articles are current as at date of publication.
This website contains information and opinions provided by third parties. Inclusion of this information does not necessarily represent Morningstar’s positions, strategies or opinions and should not be considered an endorsement by Morningstar.