Occurring on either a quarterly or yearly basis, indexes undergo a reconstitution process to ensure they remain representative of the markets they track. This reconstitution or rebalancing process, as it is also known, involves the buying and selling of stocks to make certain that the index reflects the current characteristics of its representative market. As an example, such characteristics might include capitalization or style factors currently reflected within a specific market. While index reconstitution is a common practice, the overall process can be quite impactful to portfolios that track market indices with the net effects of the process often overlooked.
A more common example of a reconstitution process is evidenced throughout the Russell indexes. These stock exchanges go through a yearly reconstitution process which is based on a market capitalization ranking of all publicly traded stocks. And while the goal is for index-tracking mutual funds to mirror the performance of the exchanges they track, the reconstitution process can yield both minimal and at times significant impacts. Such impacts range from elevated trading costs to erosion of market exposures and potential tax implications. One such example of a recent reconstitution with substantial impacts was the Russell 2000 Index June 2017 rebalancing. During this reconstitution over 200 companies were added to the index while approximately 130 companies were removed from the index. When compared to the prior year the Russell 2000 Index market capitalization, post the June 2017 rebalancing, jumped approximately 20%. So, two points that may be gleaned from this Russell 2000 reconstitution process surround trading costs and the significant exposure shifts that may be linked to reconstitutions.
The topic of trading costs is inherently linked to the performance measurement of index-tracking mutual funds which is often referred to as tracking error. Tracking error is the standard deviation of the difference between a mutual fund’s returns and the returns of the benchmark index the fund was designed to track. Index-tracking mutual funds strive for low tracking errors in an attempt to mirror the returns of the representative exchange as closely as possible. As such, when index reconstitutions occur, index-tracking mutual funds must buy the additions and sell the deletions immediately to maintain a low tracking error. Unfortunately, the universe of index-tracking funds is going through the same buying and selling process, essentially making these funds forced sellers of securities leaving little flexibility for price negotiation and generally resulting in elevated trading costs which are then passed on to the shareholder. When looking at exposure shifts, the Russell 2000 Index reconstitution led to a significant shift specifically with respect to market capitalization characteristics. Beyond the increase in the total market capitalization of the Russell 2000 Index, a result of the rebalancing, the smallest component in the Index also became 8% larger than the prior year. Given these dynamics, almost by default an index fund designed to track the Russell 2000 Index would have seen their small-cap exposure become larger as they executed trades to mirror the “new” characteristics of this index.
Another example of a more recent index reconstitution with potential wide-ranging implications was the 2018 announcement by MSCI, a leading provider of indexes, portfolio analytics, and global investment services, to add China A shares (mainland China securities) to MSCI Indexes. The initial move to include China A shares targeted a 5% exposure level and was based on increased accessibility to this market through Stock Connect, supported by a commitment by Chinese regulators to continue to support and improve access. This 2018 MSCI reconstitution announcement garnered a decent amount of attention as a new group of Chinese companies, arguably potentially less well-researched companies, was now available for investment. The benefit of this reconstitution process was that for those funds with an underweight exposure to Chinese equities the process opened up a broader means to gain this exposure.
Ultimately, the initial inclusion of China A shares in MSCI indexes through the 2018 reconstitution proved so successful that MSCI announced in February 2019 it will increase the China A shares inclusion factor from 5% to 20% over a three-step process.
As index reconstitutions have become a common practice over the past decade there have been many studies designed to identify the impact these rebalancings have on index-tracking fund trading costs and performance. While some advantages and disadvantages of these reconstitutions have been discussed above, many recent studies have indicated that improvements across exchanges, largely on the technology front, are beginning to reduce the impact these reconstitutions have on the performance of index-tracking funds. Never-the-less it is important to be mindful of the implications these reconstitutions can have on the passive universe of mutual funds.