What is reconstitution?
Reconstitution involves the revaluation of a market index. The process involves ranking, adding, and deleting stocks to ensure the index reflects current market capitalization and style.
- Reconstitution is done to ensure that the indices are properly balanced.
- The style of the index determines how often it is rebalanced. This can be from once a day to every quarter or even year.
- The same practice is applied by portfolio managers whose portfolio is their “index.”
- Rebalancing through an index has the potential to change investor sentiment regarding individual stocks based on how they rebalance.
An index fund, a subset of mutual funds or ETFs, has a portfolio that, by design, tracks the components of an established market index. Russell indices are a well-known example of a stock market going through an annual rebuild.
When considering the Russell index, all publicly traded stocks ranked in order by market capitalization form the basis for the annual reconstitution. New indices are further configured by separating stocks that have become ineligible and adding newly classified stocks. Russell indices are influential enough to be tracked by other index funds, so Russell reconstitutions tend to have a direct and immediate impact, changing the constitution of various other index funds, affecting prices and equity holdings. the investors. Other indices tracked by index funds include Dow Jones Industrials, Standard & Poor’s 500 Index (S&P 500), and NASDAQ 100.
The Russell 3000 rebuilding process works as follows between May and June of a given year: Classification day occurs in early May, which is when a preliminary list of the 4,000 most publicly traded stocks is classified and evaluated. large. The ultimate goal is to determine which of these will form the reconstituted Russell 3000 index.
Later in early June, FTSE Russell publishes preliminary changes to the list on its website. A week later, FTSE Russell publishes an updated version of this list of members. One week after that, the final reconstituted indices go into effect at the close of the market day and trade at the open of the next trading day.
The Effects of Reconstitution for Investors
The rebuilding process is an effective way to reflect the changing confidence of investors in the companies represented on these lists. With their public notifications over a series of weeks, the indices provide investors and traders with a heads up on which companies will move to and from their respective indices.
Since the stocks of the affected companies can see a big rally in buying or selling, there is a chance that the investor will quickly take advantage of these changes and potentially make a quick profit.
However, an index fund investor should remember that index managers must buy the additions and sell the exclusions in accordance with this reconstitution and nothing else; They do not make these changes based on the performance of the stocks, but rather to match the reconstituted index that the fund tracks.
The rebuilding effect, then, means that the securities added to the index will generally have higher buying demand, increasing prices and, for index eliminations, decreasing prices. Therefore, the index generally adds higher priced securities and removes lower priced securities than it would have if no assets had been tracking it because index managers seek liquidity on or near the index rebuild date.
But afterward, index managers no longer feel these liquidity demands, so the price effect usually reverses, with additions from an underperforming index and removals from a higher performing index. This can have a negative impact on the performance of all funds that track these indices.