Most equity index maintenance is routine. We explore how the COVID-19 pandemic could make things different for major index providers ahead of their regular updates.
With all that’s happened in the world in 2020, likely the furthest thing on investors’ minds is a topic as mundane as the ramifications and nuances of upcoming equity index reconstitutions. For those of us dedicated to customized implementation of equity investments across hundreds of different targets, we thrive on revealing the essential from the mundane.
We’ve heard over and over again that these are unprecedented times—and it’s true. Although this may go unnoticed by most, it’s true for major index providers as well. Many passive investors ignore at their peril that the index to which they’re benchmarked requires frequent maintenance and periodic updates as the investment landscape changes.
Index reconstitution vs. index rebalancing
Stock indexes seek to provide investable and transparent exposure to the broad stock market or a subset of the market based on a specific investing goal, such as size exposure, style exposure, or a well-defined fundamental exposure. We don’t need to look any further than the 30-stock Dow Jones—somehow still the most commonly referenced index in the media—to see that not all indexes are created equal. Despite its atypical construction, the Dow was an important and early forerunner of the modern equity index. Most major index providers develop and produce broad, cap-weighted, market-representative targets. In order to make sure those targets remain representative of the prevailing environment and relevant to investors, index providers need to adjust the holdings and weights from time to time.
Let’s distinguish between two types of index maintenance: reconstitutions and rebalances. A reconstitution is the process of changing the constituent makeup and weights to ensure the index represents the stated exposure goal, based on the prevailing inclusion rules and relative performance of the constituents. A rebalance is a periodic adjustment of existing constituents within the index without wholesale changes. Regular index maintenance related to corporate actions comes up as needed, sometimes coinciding with regularly scheduled rebalance and reconstitution dates but often not.
All indexes need to rebalance. Some do so more than others depending on the construction and goal of their targets. Strictly cap-weighted indexes experience little turnover on an annual basis because they naturally rebalance themselves. Large-cap indexes tend to have less turnover than their more dynamic and volatile small-cap counterparts. Style indexes, or indexes with other “smart beta” weighting schemes that rely on firm fundamentals, could see much larger turnover, since those fundamentals tend to be more dynamic.
The timing and periodicity of these adjustments vary by provider. MSCI institutes semiannual index reconstitutions in May and November and rebalances in February and August. Russell reconstitutes nearly all its indexes once at the end of June. In an idiosyncratic departure from the rules-based construction methodology of MSCI and Russell, S&P’s index construction is managed by committee and rebalanced as needed, with quarterly rebalances normally taking place in March, June, September, and December.
What should investors expect from June 2020’s rebalances?
The bottom line