(Re)Balancing Act
There’s no such thing as a truly passive mutual fund or ETF. Investment decisions are made in all managed strategies. What matters for investors is the guiding framework driving these decisions—is the focus on increasing an investor’s return, or satisfying arbitrary constraints?
This past July, the Nasdaq-100 Index underwent a special rebalance to trim weight in seven stocks: Alphabet, Amazon, Apple, Meta, Microsoft, NVIDIA, and Tesla. The combined weight of this group was reduced from 55.4% to 42.9% and the proceeds reinvested among the rest of the index’s constituents. These changes became effective on July 21, meaning index fund managers minimizing tracking error had to align with the new index composition by the end of trading that day.
If you’ve shopped for tickets to a Taylor Swift “Eras” tour show,1 you can appreciate the demand for trades in securities experiencing weight changes in an index tracked by more than $200 billion. Traded volumes in the seven stocks being decreased in weight were up fivefold on the reconstitution effective date compared to surrounding days.
In Demand
Trade volume for stocks decreased in weight during the Nasdaq-100 rebalance on days surrounding effective date, July 21
Past performance is no guarantee of future results.
Source: Nasdaq.
This information is intended for educational purposes and should not be considered a recommendation to buy or sell a particular security. Named securities may be held in accounts managed by Dimensional.
This surge in demand is an abnormal service request of the market. Markets will meet these demands but at a cost. Stocks changing weights during the Nasdaq-100 rebalance exhibited notable price effects on days leading up to the effective date: Those increasing in weight outperformed the index, while the opposite was true for stocks being reduced in weight. Both trends reversed in the days following the effective date.
Unscheduled Maintenance
Cumulative returns in excess of the Nasdaq-100 during period surrounding rebalance effective date, July 21
Past performance is no guarantee of future results.
Source: Nasdaq.
This information is intended for educational purposes and should not be considered a recommendation to buy or sell a particular security. Named securities may be held in accounts managed by Dimensional.
Reconstitution effects like this are a reminder that index management involves active investment decisions that may cost investors money. An investment approach that avoids rigidly following arbitrary rules can add value by making decisions that prioritize expected returns.
This article originally appeared in Above the Fray, a weekly newsletter for Dimensional clients.
Footnotes
- 1If my kids are reading this, the answer is still “No.”
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