Index Rebalancing: What Every Investor Should Know

If your portfolio includes an index fund, you may need to review and adjust your holdings.

Definition

Index rebalancing occurs when an index adjusts the weights of its assets to reflect its purpose.

What Is Index Rebalancing?

Index rebalancing is the periodic adjustment of an index’s asset weights to ensure that it accurately reflects its purpose.

An index is a collection of stocks and other assets representing a financial market segment. Just as a music service occasionally swaps out tracks in its playlists to stay up to date, rebalancing often requires index reconstitution, which is the sorting, adding, or removing of component stocks.

For example, if an index tracks the technology sector, rebalancing could involve removing companies that have pivoted away from tech. It may require adding newer, up-and-coming tech firms.

Alternatively, if the S&P 500 Index is to include the 500 largest American companies, it must periodically add or remove those that no longer meet that criterion.

Key Takeaways

Rebalancing adjusts the composition of a market index to ensure that it's accurate and relevant.
Rebalancing can cause significant shifts in trading volumes and affect stock prices, sector trends, and broader market sentiment.
Those invested in index-tracking mutual funds or exchange-traded funds (ETFs) may see portfolio adjustments, new investment opportunities, and related tax consequences.
The frequency and method of rebalancing can vary based on the index type, such as market cap-weighted, equal-weighted, or sector-specific.
Keep an eye out for rebalancing events and the potential impact so you can navigate market changes effectively and adapt investment strategies as needed.

Why Rebalance an Index?

The primary reason for rebalancing an index is to make sure that it contains the securities and weightings that are most appropriate for its objective, and remains relevant.

That’s important because investment products such as mutual funds and exchange-traded funds (ETFs) often use indexes as benchmarks.

The Problem for Investors

Over time, companies can grow in value, lose value, or change their business focus. If an index doesn't address these changes, weightings could become a problem.

For example, the best-performing companies may become overly weighted while the worst-performing companies may no longer be weighted enough. The index might not correspond to existing market conditions. As a result, it may fail to properly represent the target market segment.

That could mean trouble for investors. If an index becomes overly concentrated—say, if one sector or a few large companies begin to dominate—this could expose investors to greater risks.

Rebalancing redistributes weights across diverse assets, keeping a balanced risk profile. That ensures that an index remains an accurate and suitable tool for investors.

Fast Fact

Approximately $16 trillion in assets track the S&P 500 Index. With every rebalancing, asset managers who use the index as a benchmark must be careful to adjust their assets to match any changes to the risk and return profile of the index.

How Is an Index Rebalanced?

Index rebalancing involves:

An initial review of assets
Setting inclusion criteria based on market conditions
Making adjustments to asset weights
Potentially adding or removing specific assets

Understanding how index rebalancing is done can demystify this essential process and its effects on your investments as well as the market at large.

Let's dive into how it works.

Initial Review: Assessing the Current Landscape

Data gathering: The index manager collects data on all companies or assets in the index, as well as potential candidates for inclusion.
Performance analysis: Past performance, trends, and the market capitalization of companies whose shares are held are evaluated to gauge how they align with the index’s objectives.

Setting the Criteria: The Rulebook

Market capitalization: A minimum market cap is often set to ensure that the index only includes companies with a significant market presence. Some indexes also have market cap specifications. For example, the S&P 500 only includes large-cap companies, while the Russell 2000 only includes small caps.
Liquidity: Stocks must often meet specific minimum trading volume criteria to ensure they can be easily bought or sold.
Sector representation: An index may aim to have a diverse set of companies from various sectors. Other indexes might focus on stocks within a single industry.
Other factors: These could include dividend yields, price-to-earnings ratios, or geographic distribution, among others.

Selection and Deselection: Making the Cut

Identify candidates: A list of potential new entrants and possible exits is made, based on the criteria.
Vetting process: A committee usually reviews the list to ensure it aligns with the index's overall objectives.
Final list: After further scrutiny, the final list of companies to be added or removed is prepared.

Weighting: Balancing the Scales

Methodology: Indexes usually use market-capitalization weighting, though other methods include equal and revenue weighting.
Calculation: The weight of each company in the index is recalculated, based on the method used.
Normalization: The index is often “normalized” to have a specific starting value, which makes tracking its performance over time more manageable.

Implementation: Rolling Out Changes

Announcement: The index administrator publicly announces the changes, usually a few days or weeks before the effective date.
Adjustment period: During this time, the market can adjust to the announcement, and trading volume typically increases.
Adjustment: Stocks that no longer meet the criteria are removed, and new stocks are added.
Weighting: The index is then weighted again based on the updated stock list.
Effective date: At this point, the index officially adopts the new changes, and the rebalanced index is launched.

Example of Index Rebalancing

The S&P 500 is a widely followed index of 500 large-cap U.S. companies. It represents the most commonly used performance benchmark of large-cap companies in the U.S. stock market.

S&P Dow Jones Indices maintains the S&P 500 Index and selects the companies to include based on criteria like market capitalization, liquidity, financial viability, and sector representation.

During a rebalance, the weights of the different shares in the index are adjusted to reflect their latest share counts and float. Companies may be added or removed based on the eligibility criteria.

December 2024 Rebalancing

S&P Dow Jones Indices announced its fourth quarter S&P 500 Index rebalancing on Dec. 6, 2024. The rebalancing added Apollo Global Management (APO), Workday, Inc. (WDAY), and Lennox International, Inc. (LII) to the index.

It removed Amentum Holdings, Inc. (AMTM), Qorvo, Inc. (QRVO), and Catelent (which was acquired by Novo Holdings in December 2024).

While weight changes were modest, the financial sector had the largest weight change, followed by the information technology sector.

The S&P 500 is rebalanced quarterly, usually on the third Friday of March, June, September, and December. However, changes can also occur intra-quarter if a company becomes ineligible after a merger, acquisition, bankruptcy, or delisting.

How Index Rebalancing Impacts the Stock Market

Changes in Trade Volume

An immediate and visible impact of index rebalancing is increased trading activity. Institutional and retail investors react as index providers announce the stocks to be added or removed from an index.

For example, asset managers who run index funds or index ETFs must scramble to adjust their portfolios to match the new index composition, increasing the trading of specific stocks.

This surge in trading can be significant, and it's often seen as a short-term opportunity for experienced traders specializing in arbitrage.

Market Volatility

An increase in trading activity often leads to volatility for the stocks involved in the rebalancing. Shares newly added to an index often have a price boost as index-following funds buy them.

Conversely, those being removed may dip in price as they are sold off. While these price changes are generally temporary, they can present challenges and opportunities for active investors.

Changes in Sector Trading

Rebalancing can also generate sector shifts in the market. For example, if an index adds technology stocks and removes those from the energy sector, it can drive up demand for tech stocks while reducing the appetite for energy shares.

Although only connected to the index initially, these shifts can extend to the broader market, influencing sector-based funds and individual stock performance.

Fast Fact

When a company is added to a prestigious index like the S&P 500, it’s seen as a vote of confidence that can positively influence investor sentiment toward that company. Similarly, removal from an index is seen as a negative indicator.

What It Means for Individual Investors

For those who invest in index funds or ETFs that aim to replicate the performance of a particular index, rebalancing can lead to the need to adjust portfolios.

When an index is rebalanced, the index fund or ETF that tracks it will modify its holdings to match the new composition.

As an investor, you’ll see shifts in your asset allocation, which might dictate reviewing and rebalancing your portfolio to ensure it still aligns with your financial goals.

Long-Term Investors

For buy and hold investors, the implications of rebalancing might not be immediately apparent, though they could become significant over time.

If an index continually shifts its focus—say, from value-oriented companies to growth-oriented ones—it may no longer serve as a suitable benchmark for your particular investment strategy.

In such cases, you might reconsider your investment choices and look for alternative index-tracking funds that better match your long-term goals.

Short-Term Investors

The announcement of index rebalancing can present short-term trading opportunities.

Stocks added to an index often have a temporary price boost based on increased buying activity, while those being removed may dip in price.

Savvy investors can leverage these fluctuations for short-term gains, although it’s essential to approach this strategy with caution and analysis.

Important

When an index fund or ETF adjusts its portfolio, capital gains or losses may result. These are often passed to investors, who must report them on their tax returns. Understanding the potential tax consequences of index rebalancing can help you take steps to mitigate your tax burden.

How Often Is an Index Rebalanced?

The frequency of index rebalancing depends on the index in question. Some indexes, like the S&P 500, are rebalanced quarterly, while others are adjusted semiannually or annually. Specialized or thematic indexes might have unique rebalancing schedules. A rebalancing may also occur between scheduled evaluations because of rapid changes in the market. Knowing the rebalancing schedule of the index you’re interested in is crucial, as this will affect your investment strategy.

Do All Indexes Undergo Rebalancing?

Market-cap-weighted indexes like the S&P 500 must undergo regular review and rebalancing to ensure that market capitalization weights are aligned with their underlying stocks or that specific sector weights are in line. Alternatively, price-weighted indexes like the Dow Jones Industrial Average are more influenced by the stock prices of their components than their market capitalization. As a result, these indexes might rebalance less frequently, typically when a stock undergoes a split or when one company is replaced by another.

In rare circumstances, you might encounter indexes that do not undergo rebalancing at all. These usually are used for historical or academic purposes rather than active investments or benchmarking. They are not designed to represent current conditions.

Is Index Rebalancing Good or Bad for Individual Investors?

Rebalancing has mixed effects on individual stocks and is often neutral for ordinary investors. A company that's added to an index can see a positive boost in its stock price and liquidity because of increased demand. Conversely, being removed from an index can lead to a price decline and be perceived negatively. However, these effects are generally short term and often balance out over time.

What Is the Difference Between Index Rebalancing and Portfolio Rebalancing?

Index rebalancing refers to adjusting the components of a market index, like the S&P 500. Portfolio rebalancing is undertaken by individual investors to realign their portfolios with their investment goals. While index rebalancing can require portfolio rebalancing, they are distinct and serve different objectives.

The Bottom Line

Understanding index rebalancing can arm you with the knowledge to improve how you navigate the investment landscape.

Whether you're an individual investor or studying finance, knowing how and why indexes are rebalanced can help you make more informed decisions that align with your financial goals.