Index Rebalancing: What Is It And How Does it Work?

While an index fund is often referred to as being “passively managed” there is plenty of action happening behind the scenes. In fact, one of the key responsibilities of index fund managers (such as ourselves) is ensuring that the balance of our funds accurately reflects the index that it is tracking.

This is done partially through regular updates or “rebalances,” which are changes to an index’s holdings and weightings, usually quarterly. More importantly, index fund managers must reconfigure portfolio holdings to match the rebalanced index to continue to achieve their index-tracking objective.

But before we get into the nitty gritty of rebalancing, let’s start with the basics.

A stock index, at its core, is designed to measure the performance of a market or a part of a market. It does this by calculating the collective price movements, and therefore performance, of the selected stocks that are within the index.

The result – is a portfolio of equities that are generally ranked on how well they fit the criteria of the pre-determined methodology. To ensure stability and a true representation of the index, it is necessary to regularly both:

1. Reassess the constituents (companies in the index) to ensure that they still meet the relevant criteria, and

2. Determine an eligible ‘universe’ of other companies to scout any possible additions.

This process is called rebalancing (or reconstituting) and occurs only a few times a year, usually quarterly or sometimes semi-annually. It is the process of realigning the index back to its specified criteria and requirements.

During a rebalance, current constituents are reassessed, reweighted and dropped if necessary. This differs from a reconstitution where a new eligible universe is constructed, starting from scratch, rather than incumbents having some priority.

Each index has a pre-determined methodology that is set out by the index provider. Kernel’s index provider is Standard & Poor’s, who run the most followed index in the world - the S&P 500, along with thousands of others.

S&P is responsible for ensuring that the composition of an index adequately reflects its stated methodology. Meanwhile, Kernel is responsible for ensuring that we match that index as closely as possible and making sure that S&P are doing their job correctly by performing our own checks. Kernel and S&P maintain a strong relationship, allowing us to partner in creating new indices (such as the NZ50 ESG Tilted) as well as maintain or tweak existing ones.

Kernel licenses daily files from S&P on all indices that we track. These files contain information about corporate actions, rebalances, methodology changes, additions, deletions, spin-offs, or anything that may change the weighting or profile within an index.

These daily files allow us to make minor adjustments to our funds as we see fit to track the relevant index more closely. For example, because of a corporate action a company may be dropped from the index before a rebalance day, or the impact of a capital raise might be accelerated for inclusion because of its size or nature.

Although index funds are technically referred to as ‘passively’ managed, the reality is there is a lot to stay on top of with the 19 funds (As at July 2023) that collectively hold over 1000+ stocks. t least to do it well with a minimal difference to the mathematical equation that is an index value.

A market capitalisation (“market cap”) weighted index involves constituents being included and ranked based on their free float market capitalisation. Market-cap is the total dollar value of all a company’s free float shares multiplied by the current share price.

Free float means that it is ‘available to sell’, this means the proportion of shares that are held by investors like founders or governments are not included in this calculation.

Air New Zealand or utility companies like Vector and Mercury are current examples of companies that have a lot of their shares locked in by the New Zealand Government and are considered not interested in selling based on financial value.

Kernel’s Global 100 and NZ 20 are designed to be market cap weighted, aiming to hold the largest 100 global companies and the largest 20 companies listed on the NZX, respectively.

On the other side of the fence, we have indices that don’t use market capitalisation as their primary source for inclusion and rank. The requirements for these often follow an investment theme or sector.

Constituents that meet the relevant ‘theme’ or ‘sector’ requirements are then ranked by either how well they fit the theme, by size, or are all given an equal weighting.

A great example of this is the index behind the Kernel Global Dividend Aristocrats Fund. To be considered a Global Aristocrat, a company must have increased or maintained dividends for at least 10 consecutive years, and simultaneously have positive returns on equity and cash flows from operations.

From here, constituents are ranked and weighted based on their annual dividend yield, with no stocks being allowed to make up more than 3% of the index, or less than 0.05%. This index also has a monthly dividend review, where companies are immediately dropped if they cancel or reduce dividend payments.

Then it’s a long time before they are allowed back in!

Rank buffers are a tool used in market-cap-weighted indices, with the goal of reducing change within the index brought about by short-term market fluctuations and not regularly promoting and relegating companies.

The S&P/NZX 20 index has an addition rank buffer of 16th or higher and a deletion rank buffer of 24th or lower.

This means that a company must become the 16th largest company to ‘push out’ the 20th-ranked company from the index. In the same way, it's only when a company in the index falls to be 24th largest according to criteria that it will be removed and replaced in the S&P/NZX 20 index.

Rank buffers reduce churn, being companies dropped/added due to some temporary market movement. They ensure that a company is truly large enough to now be included and likely stay in, or vice-versa well outside the criteria and hence excluded.

Index rebalancing is not to be confused with portfolio rebalancing. A portfolio rebalance would involve an investor realigning their investment goals back to what they set out to be, after the market has shifted them.

For example, if an individual decided to invest 60% into stocks and 40% into bonds, they may find in a year’s time that due to stocks performing relatively better than bonds, their portfolio now comprises of 70% stocks and just 30% bonds.

This person would then rebalance their portfolio by selling stocks and buying bonds to realign their portfolio back to the desired 60/40 allocation.

There is a lot that goes on behind the scenes when it comes to managing an index fund. Little details such as liquidity management, high-quality execution, tax efficiencies, low transaction costs, and effective rebalancing all play a part in the performance of a fund closely tracking its chosen index.

Rebalancing plays a key role in maintaining the index fund manager’s objective to track the index and is one of the many skills that they regularly manage to give investors the performance they expect.