Out with the Old, in with the New: The Importance of Index Rebalancing for Investors
Regardless of what kind of method is being used to calculate, stock market indexes need to be rebalanced periodically to maintain their accuracy and relevance. Rebalancing involves adjusting the weights of the components of an index to reflect changes in the market or in the individual stocks. The frequency and criteria for rebalancing varies depending on the index and the methodology used to calculate it.
Here are a few reasons why stock market indexes need to be rebalanced:
Changes in market capitalization: As the market capitalization of a company changes, its weight in the index needs to be adjusted. For example, if a company's market capitalization increases significantly, its weight in the index will also increase, which can skew the performance of the index. Rebalancing ensures that the index accurately reflects the market capitalization of the companies included in it.
Changes in the number of shares outstanding: Stock splits, reverse stock splits, and share buybacks can all affect the number of shares outstanding for a company. As a result, the weight of the company in the index needs to be adjusted to reflect these changes.
Changes in the sector or industry: Over time, some sectors or industries may become more or less significant in the market. For example, the technology sector has become increasingly important in recent years, and the weight of technology companies in stock market indexes has increased accordingly. Rebalancing ensures that the weight of each sector or industry in the index accurately reflects its importance in the market.
Annual or semi-annual review: Many stock market indexes have a regular review period, usually once a year or twice a year, during which the components of the index are re-evaluated and rebalanced if necessary.
Rebalancing a stock market index can have significant impacts on the performance of individual stocks and the index as a whole. It can also create opportunities for active investors to take advantage of market inefficiencies or mispricing that may arise from the rebalancing process.
OCBC NISP Ventura
February 2023 Newsletter