Index management: Rebalancing and reconstitution
Rebalancing is the practice of adjusting the weight of securities in an index according to the methodology used in making the index. The change in the price of securities necessitates rebalancing and it leads to turnover (buying/selling) of securities. Rebalancing of price and market capitalization-weighted indices happens automatically and hence is not a concern.
Reconstitution is the practice of adding or deleting securities from an index based on whether the securities are meeting the index criteria or not. It is a part of rebalancing exercise. It is required to reflect the changes in securities value (driven by merger and acquisition, bankruptcy, delisting etc) or change in subjective view of the selection committee. The frequency of reconstitution can be different. Investment managers use many of these indices as benchmarks. Hence, addition or deletion of securities in indices can lead to significant up or down move in the security prices (investors will look to add or drop the security from their portfolio as well).
Check your concepts:
(46.6) Which of the following weighted indices is most likely to be rebalanced every period?
(a) Market capitalized weighted index
(b) Equal-weighted index
(c) Price-weighted index
(46.7) If a high-priced security is replaced with a low priced security in a price-weighted index then what will be the most likely impact on the value of the index?
(a) Increase
(b) Decrease
(c) No change
(46.8) On replacing a low priced security with a high priced security, the weight of all other securities in the index increases. The index is least likely to be a(n):
(a) Equally-weighted index
(b) Price-weighted index
(c) Market-capitalized weighted index
Solutions:
(46.6) Correct Answer is B: Equal-weighted index needs rebalancing every period with unequal changes in the security prices. The market capitalized weighted indices and price-weighted indices get rebalanced automatically with the change in the prices.
(46.7) Correct Answer is C: When a security is replaced with another security then the value of the divisor is changed so that the index value remains the same. The index value would change only in the next period depending on the performance of the constituent securities.
(46.8) Correct Answer is B: On replacing the low priced security with a high priced security, the weight of the other constituent securities should decrease in the price-weighted index.
Exam Alert: Rebalancing is an important topic in this chapter. Candidates must always remember that no rebalancing is required for market capitalized weighted index and price-weighted index due to the change in the prices of the constituent securities. However, the rebalancing is required in all types of indices if the securities are getting replaced.
