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What You Don't Know

What is Index Reconstitution and How Does it Affect Investors?

02/14/2019

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Index funds have become incredibly popular over the last few years. In fact, these passive investment funds already hold nearly 30% of the market’s assets – and that number is expected to continue to rise.
The promise of low costs, easy diversification, and simple investing solutions has caused many investors to flock to these funds as they seek to make the most of their investment money. However, there is a lot that people don’t understand about index funds and how that may affect their goals and outcomes.
Index reconstitution, for example, is one feature of index funds that is often overlooked by the average investor. Despite that lack of attention, reconstitution is one of the most important aspects of index funds and it can have a massive impact on many areas of investor’s lives.
This article will take a closer look at index reconstitution and what this means for the average investor as they look ahead and plan for their future.

What Exactly is Index Reconstitution?

Index reconstitution is sometimes also referred to as rebalancing. These terms are often not talked about a lot when people discuss index funds but index reconstitution is one of the most important features of an index fund.

To first understand index reconstitution, you must understand the fundamental construction of a typical index fund. These funds hold a large bucket of stocks that are designed to track a specific index or industry. Investors who wish to invest in that industry and diversify their portfolio can choose an index fund to simplify their investing.

While index funds are generally more passive investments than most actively managed funds, there is still the need for reconstitution in cases where the fund is straying from its original allocation goals. This could be due to high performance or low performance from certain stocks. As the individual assets within the bucket gain or lose value, the percentage of total value that they make up within the index fund may change and, as a result, the index fund may no longer accurately track the industry or index it was designed to replicate.

When this happens, index funds must rebalance their massive portfolio of stocks which typically involves selling some shares and buying others. Since many index funds hold billions of dollars in value, the purchases made by the fund could be massive and have major implications in the market. This is true even if you are not an investor in the specific index fund doing the rebalancing.

The Tax Implications of Index Reconstitution

When index funds sell shares, many of those sales could incur capital gains taxes if they were sold at a profit. While it is better to gain money on an asset than lose money, these taxes could have a major impact on the individual investors in the fund.

The main reason for this impact on individual investors is because of the rules surrounding taxes in large investment funds. These index funds cannot simply absorb tax responsibilities. Rather, those taxes must be passed on to investors in the fund. If a large index reconstitution was needed to bring the fund back in line with its intended goals then the tax implications could be huge.

Taxes are, of course, just an accepted part of life. However, many people try to invest wisely in order to limit their tax bill as much as possible. For investors that have chosen passive investments like index funds, getting a large tax bill come tax season can be a bit of an unwelcome shock. This is one of the aspects of index reconstitution that often goes unmentioned but it is definitely something individual investors should be aware of.

The Costs Don’t End There

Taxes are just one part of the costs that can arise as a result of index fund reconstitution. As funds sell and buy shares to rebalance their holdings, trading fees must also be factored in. When trading at the amount that index funds trade, the fees incurred can be significant.

Of course, much like capital gains taxes, index funds cannot simply absorb fees. Rather, those trading fees must be passed onto investors. These fees can chip away at gains and, if the index has underperformed in a down market, those fees could accentuate losses. Both scenarios are obviously not ideal for the average investor.

Of course, if an index fund manager is cognizant of fees, they can limit trading to times when it is only necessary. However, they cannot put off trades forever if reconstitution is necessary to bring the fund back in line with its original goals.

The Mix of Stocks May Not Always Look Nice

An actively managed fund seeks to choose which stocks will be winners and losers in the market. If done right, the fund manager will exceed the average returns of the market. Index funds, however, seek to replicate the performance of an index or industry – minus costs and fees. As a result, these funds hold a large bucket of stocks with a wide selection of companies that represent the index or industry in question.

Within the holdings of an index fund will often be winners and losers. For every high performing stock there could be many more average stocks and even a few that are lagging behind the rest of the index. This is just an accepted fact of index investing. Even with index reconstitution, funds will often buy stocks that may not be the darlings of the market.

You must always remember that an index fund is meant to replicate the average performance of an index or industry. This means that there are some shares which will outperform the average and some that will underperform.

Index funds are not always full of high-quality assets – and that is an uncomfortable fact that often goes overlooked when talking about the many benefits of index investing.

Index Reconstitution Can Impact the Entire Market

If one of the large index fund companies like Vanguard or BlackRock need to purchase or sell shares, these companies, with hundreds of billions of dollars in holdings, can have an impact on the entire market. Even if you are not an investor in the funds in question, your investments could be affected by index reconstitution.

Large sales of shares can push prices of shares down as selling pressure exceeds buying demand. For owners of the share in question, this could mean a drop in portfolio value despite no real fundamental changes in the company in question. As these index funds buy shares, the massive buying pressure can send the prices of stocks upward. Again, this may have nothing to do with the performance of the company being traded.

Those that believe in the efficient market theory will argue that share prices will always reflect their actual value and these massive trades are simply bringing stocks in line with their real value. However, it is hard to ignore the effects that one or two massive players in the market can have on stock prices.

Investors Will Trade Based on Index Fund Reconstitution

As mentioned, when these massive index funds make trades to rebalance their holdings, the moves can impact the market whether or not you are an investor in the fund itself. Many investors closely watch the movements of index funds to look for trading opportunities.

When index funds sell large blocks of shares they can move the market price of these shares downward. On the other hand, when they buy shares, they can move the market price of shares upward. In many cases, these changes are only temporary as a response to the massive pressure created when large index funds make waves in the market.

In order to take advantage of these temporary changes in the market, some investors will buy shares that have had their price depressed by index funds selling, then sell the shares for a profit after the price has recovered.

In the event that an index fund is buying assets, the price may be artificially driven upward for a short time. Many investors will sell at this point to take advantage of the change in the market. If the asset was something they wanted to hold long term then they will buy back in once the price adjusts after a return to normal trading activity.

Of course, both examples mentioned are a calculated risk taken by investors.

Understanding Index Reconstitution is Important

This article is not meant to drag index funds through the mud. Rather, this is meant to shed some light on an aspect of index funds that often goes undiscussed when investors learn about the features and benefits of index investing.

While there are some downsides to index reconstitution, it is a necessary part of managing an index fund. Plus, as you can see, there are ways to take advantage of index reconstitution whether or not you are an investor in the fund.

 

DISCLOSURES

Linden Thomas and Company and its affiliates do not provide tax, legal, or accounting advice. This material has been prepared for informational purposes only, and is not intended to provide, and should not be relied on for, tax, legal or accounting advice. You should consult your own tax, legal and accounting advisors before engaging in any transaction.

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