LOS F. Describe rebalancing and reconstitution of an index.

Question 1

Most important for equal-weighted indexes.

Answer 1

Index providers periodically rebalance the weights of the constituent securities.

Question 2

Reconstitution: changing the index

securities (changing the index list)

Answer 2

• Some indices are reconstituted on a
regular basis.
– Indices whose security lists depend on
objective criteria are regularly
reconstituted.
• Others are reconstituted as needed.
– Often when companies go bankrupt or are
acquired.

Russell 1000 Example
• The Russell 1000 index includes the
1000 largest US stocks, by
capitalization.
• The list changes as stock values
change.
• The index is reconstituted once a year
in June.

Reconstitution refers to changing the securities that are included in an index. This is necessary when securities mature or when they no longer have the required characteristics to be included. Reconstitution of an index refers to: removing some securities from the index and adding others.

Reconstitution begins with evaluating the securities in an index against the index’s criteria. Securities that are no longer representative of the index are removed and replaced with different securities that do meet the criteria. Adjusting the weights of the securities that constitute an index is termed rebalancing.

When a security is added to a widely followed market index, the security’s price is most likely to: increase.

Adding a security to a market index typically causes an increase in that security’s price as portfolio managers who track the index purchase the security.

The providers of the Smith 30 Stock Index remove Jones Company from the index because it has been acquired by another firm, and replace it with Johnson Company. This change in the index is best described as an example of: Reconstitution refers to changing the securities that make up an index. Reconstitution of an index is required if one of its constituent securities goes out of existence (for example, a maturing bond or an expiring futures contract) or no longer meets the requirements to be included in the index.

Question 3

Rebalancing: changing the index

weights

Answer 3

Rebalancing price Weighted Indices• Price capitalization weights change
through time, but the associated index
portfolio does not need to be
rebalanced because the portfolio
positions change in proportion to the
weights.
• Need to rebalance when splits occur.

Rebalancing Market
Capitalization-Weighted Indices:Market capitalization weights change
through time, but the associated index
portfolio does not need to be
rebalanced because the portfolio
positions change in proportion to the
weights.
• No need to rebalance when splits
occur.

Rebalancing Equal-Weighted
Indices: • Equal-weighted indices are rebalanced
periodically because prices change.
• The index provider sets the rebalancing
interval.
• The weights on appreciated securities
are decreased and those on
depreciated securities are increased. • The replicating portfolio for an equal weighted
index is an actively managed
contrarian portfolio.
• Index values increase when prices have
a mean-reverting component (bounce
up and down).

Rebalancing Fundamental-
Weighted Indices: • Fundamental variable change through
time, which requires that the
fundamental weights change.
• No need to rebalance when splits
occur