With Major Indexes Set for Rebalancing, How Has 2020 Reshaped Passive Investing?

With Major Indexes Set for Rebalancing, How Has 2020 Reshaped Passive Investing?

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Andrew Subkoviak, CFA

Senior Investment Strategist

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Rey Santodomingo, CFA

Managing Director, Investment Strategy (emeritus)

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.

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What should investors expect from June 2020’s rebalances?

It would be an understatement to say the current environment is abnormal. Cross-sectional volatility has been high, with some sectors like technology and health care faring much better than others. The largest mega-cap companies have emerged from the evolving crisis in better shape than others, increasing concentration in the market. Growth stocks have continued to outperform value stocks by a remarkable 15% to 20% year to date depending on your chosen benchmark. As the winners separate themselves from the losers in the wake of the COVID-19 crisis, a transformation is taking place in the broad economy and the investment universe alike. The transformation extends to index construction and implies the possibility of a lot of movement among and between different indexes.

With the economic recovery approaching the precrisis highs of February, with new constituents and sectors leading the way, S&P and Russell’s June rebalances loom ahead. As investors navigate the massive swell that began in February, bottomed in March, recovered strongly in April, and extended through May, they may have overlooked the S&P committee’s decision to postpone its regularly scheduled March rebalance. The S&P committee, typically dedicated to very low-turnover rebalances, will be left with the dilemma of whether to consider the recent disruptions resulting from the pandemic as long-term and whether to honor them in part or in whole. The committee exercises some judgment here, since they don’t automatically eliminate companies that fall below stated cap thresholds. 

Russell appears set for a slightly larger than normal rebalance in 2020 thanks to its once-annual reconstitution. Preliminary estimates indicate typically low turnover in its large-cap and broad-cap flagship indexes. As a result, any additional turnover will have a low to moderate impact for the vast majority of passive investors. Russell’s style indexes are poised to turn over around 15% or more, with many companies moving from growth to value. This is the result of the style methodology of assigning normalized scores for securities along the growth and value spectrum based on a composite of firm fundamental data and targeting 70% market cap coverage in both styles. The upshot is a high-turnover event because of constituent reranking based on disparate financial results and an increasingly concentrated cap-weighted reference index.  

The bottom line

Turnover matters to the taxable investor. In generally rising markets, high-turnover benchmarks and large-turnover rebalancing events are by their nature tax inefficient. In order to continue tracking the chosen benchmark exposure, the portfolio needs to mirror the benchmark in terms of turnover. Tax-efficient portfolio managers can often limit the turnover to less than that of the benchmark, defer gains, accelerate losses, and efficiently manage the benchmark-relative risk exposures. Managers need not blindly liquidate names that are no longer in the index, although they must carefully consider the extent to which a portfolio contains excessive nonbenchmark exposure.

The first quarter of 2020 was a rich environment for tax-loss harvesting. In many client accounts that were loss-harvested in Q1, the forthcoming index rebalances might result in net gains that reduce the tax benefits accrued year to date if the client wants to continue tracking their chosen benchmark.

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