Lesson 5 of 7 · 13 min
Rebalancing, reconstitution and what indexes are used for
Rebalancing resets weights to the index's rule and reconstitution changes which securities are in it; both create turnover, and the finished index then serves as a sentiment gauge, a market proxy, an asset-class proxy, a benchmark and a model portfolio.
In short
- Rebalancing = adjusting constituent weights back to the weighting method on scheduled dates, usually quarterly. It is needed because prices move weights.
- Equal-weighted indexes need the most rebalancing; price-weighted indexes are never rebalanced; cap-weighted indexes largely rebalance themselves (adjusted only for corporate actions).
- Reconstitution = changing the constituents: re-apply the inclusion criteria, retain, remove or add securities, then re-apply the weighting. It keeps the index representative of the target market.
- Both create turnover; anticipated reconstitution can push up prices of likely additions and push down likely deletions.
- Uses: market sentiment gauge; proxy for returns, systematic risk and risk-adjusted performance; proxy for asset classes in asset allocation; benchmark for active managers; model portfolio for index funds and ETFs.
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