Stock Indexes Are Changing. Is Your Portfolio Prepared? | The Informed Investor 48

Episode 48: Does "index reconstitution" help or hurt everyday investors?

The phrase refers to periods when stock indexes are rebalanced—when stocks are added to or dropped from an index (like the S&P 500 or Russell 2000 Index), often annually, semiannually, or quarterly.

If you own index funds, which attempt to track the returns of indexes, reconstitution events may take a hidden bite out of your returns.

The problem is that index funds tend to buy and sell the same things when index providers reconstitute their indexes, creating a massive demand for liquidity that can reduce value for investors.

Research by Dimensional shows that average daily trading volume for stocks added or deleted tends to rise 20x to 50x higher over the following days and weeks. https://www.dimensional.com/us-en/insights/measuring-the-costs-of-index-reconstitution-a-global-perspective

This process typically begins when index providers publicly announce changes ahead of time.

Sophisticated traders such as hedge funds will get ahead of these trades, acting as liquidity providers to index funds. This typically pushes prices up before index funds buy and down before they sell. As a result, index fund managers systematically buy high and sell low, cutting into performance for both the index fund and the index itself.

But these trading costs are not reflected in the fund expense ratio, and they affect both your investment and the index, creating a hidden cost for investors.

Another potential cost of reconstitution is what's known as style drift.

This phenomenon occurs when a fund's holdings drift from the targeted objective or asset class—often due to infrequent rebalancing.

While the characteristics of individual stocks evolve every day, holding a stale roster of names due to infrequent rebalancing may lead investors to miss out on opportunities for outperformance.

Fortunately, everyday investors don't have to settle for the hidden costs and the lower return potential tied to index reconstitution.

In Episode 48 of The Informed Investor, Dimensional's Mark Gochnour, Head of Global Client Services, Rob Harvey, Co-Head of Product Specialists, and Jake DeKinder, Head of Client Communications, explain how index reconstitution events impact your investment opportunities and what investors can do to help minimize the potential costs.

LINKS FROM TODAY'S EPISODE: 

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"The Informed Investor" on YouTube [update with live link]

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Mark Gochnour on LinkedIn https://www.linkedin.com/in/mark-gochnour-9a23598a/

Rob Harvey on LinkedIn https://www.linkedin.com/in/robkharvey/

Jake DeKinder on LinkedIn https://www.linkedin.com/in/jake-d-4105b98/

Learn more at https://www.dimensional.com/