Index Rebalancing Explained With Nasdaq

Jan 4, 2022 05:17 PM ET
Index Rebalancing Explained With Nasdaq

Indexes, in simple terms, are stock exchange-created portfolios that only comprise the best-performing companies on the market. These companies are included in the indices because they have met certain set requirements. An essential consideration may be the company's market value. However, depending on the index, these criteria may be different. 

The phrase "rebalancing" refers to the act of redistributing the assets in a portfolio or index in order to achieve a more even distribution. Rebalancing an investment portfolio is, therefore, a change made in order to maintain the portfolio's balance and diversification as originally intended according to the approach described in the original plan.

This can be accomplished in a variety of ways, such as by adding or removing titles or by purchasing or selling shares to alter the "weights" of various current components.

A well-balanced portfolio can only be maintained over the long term through regular rebalancing. Similarly, in terms of stock indices, the technique tries to maintain the index's composition throughout time.

In most cases, indexes rebalance their components on a predetermined schedule. These, however, can differ from one index to another.

The rationale for rebalancing indexes

An index's fundamentals, like earnings and dividends, must be checked periodically to ensure that the index is still a good representation of the underlying stocks.

Market indexes are created for the purposes of representing and quantifying the performance of securities in one or more markets, asset classes or sectors, or investment strategies. As an aggregation of financial instruments, indexes are not directly investable because they are financial calculations.

Index providers must ensure that the index's composition accurately reflects the methodology they have described in their product descriptions. Rebalancing or updating an index's holdings and holding weights is a key element of this process. In order to maintain their index-tracking goals, managers of index funds must rebalance their portfolio holdings to reflect the rebalanced index. 

Stocks are typically included or removed from an index, or the weightings of already-included stocks are adjusted on a regular basis by most index providers. In general, index rebalancing occurs on a regular basis; however, the exact day and time may differ from one supplier to the next. Index rebalancing occurs, for example, on the third Friday of each calendar quarter on the S&P Dow Jones Indices.

Rebalancing vs. reconstitution

The act of modifying an index's component securities is known as "reconstitution." Stocks are only included in the index if they meet the requirements for inclusion.

Market cap is one of the criteria used to determine whether or not a company is allowed to continue in the index. The index removes corporations that fail short and replaces them with companies with bigger market capitalization.

The case of the Nasdaq Index

In the minds of many investors, the Nasdaq is synonymous with high-tech stocks. Despite this, its composition and operation are among the least well-understood of the major indices. Consumer service and healthcare companies make up around 20 percent of the index, while tech firms comprise roughly 50 percent. Utilities, oil, and telecommunications businesses make up the rest of the market.

All of the companies listed on the Nasdaq Stock Market go into the Nasdaq Composite Index. For inclusion in the index:

  • The stock must only be traded on the Nasdaq exchange.
  • The common stock of a single company is required, thus preferred stocks and exchange-traded funds (ETFs) don't count.
  •  Shares in limited partnerships and American Depositary Receipts (ADRs) may be eligible, as well as Real Estate Investment Trusts (REITs).

More than 3,000 stocks are included in the Nasdaq Composite, and the index frequently moves as a result of this. Rather than representing only the largest companies, the index is intended to represent the whole Nasdaq stock market as a whole.

Market capitalizations are used to determine the weighting of the Nasdaq Composite's constituent stocks. This means that a shift in large-company stocks has an even higher impact on the overall index performance as compared to a move in small-company stocks.

As an example, a $500 billion Nasdaq-listed common stock would have twice as much impact on the index as a $250 billion market cap company if their percentage price movements were similar.

The Nasdaq Composite is a market-cap-weighted index, which means that each firm included in the index is given a weight based on the market value of its outstanding shares. As a result, the performance of the index is influenced more by large companies with higher capitalizations than by smaller ones.

There are two indices on the Nasdaq Stock Market: the Nasdaq Composite Index and the Nasdaq 100 Index.  The larger Nasdaq Composite consists of all listed domestic and international stocks, while the Nasdaq 100 index is an exclusive club of the 100 largest companies by market cap. In addition, the Nasdaq 100 excludes all financial stocks such as those of banks. 

It is possible for index adjustments to occur during the year, however, if a firm is bought or if stocks fail to meet the 'Continued Eligibility Criteria,' which include becoming too small throughout the year. Historically, roughly 10% of the Nasdaq-100 companies are removed from the index each year. A rebalance of the Nasdaq-100 takes place on the third Friday of December each year.

In summary

The term "rebalancing" refers to the periodic adjustment of the weights of the index's component securities. Rebalancing is done to achieve specific set objectives for an index, and it may change from time to time depending on the companies that meet certain eligibility criteria. When it comes to the market capitalization index, it's less of an issue than with price-weighted indices because the latter tend to rebalance on their own, making it less of an issue.



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