Say you had a crystal ball and while gazing into it you discovered that a few days hence three particular stocks were going to be hit with enormous buy orders while a different three would have a huge sell off. What do you suppose might happen? It would not be unreasonable to assume that mere moments later traders would get themselves ready to make a nice easy and quick profit. Well, that is what an Index reconstitution is all about.
What is an Index Fund?
Keep in mind that an index fund is a type of mutual fund or ETF with a portfolio constructed to match or track the components of an established market index, such as the Standard & Poor’s 500 Index (S&P 500), Dow Jones Industrials (DJ30), or NASDAQ 100. An index mutual fund provides broad market exposure, low operating expenses and low portfolio turnover and does not try to “beat the market” but rather capture market gains in a low cost manner.
The powers that determine those companies that comprise an Index, announce in advance the companies that they are adding as well as those that they are dropping. As a result, the volume of the shares traded on a specific day will be greatly in excess of the normal daily volume of those specific holdings.
For example, last month, on September 20th to be exact, the DJ30 added to its components Visa, Nike and Goldman Sachs while dropping Hewlett-Packard, Bank of America and Alcoa.
By definition, index funds like the DJ30 must mirror exactly their index’s holdings, as such they have no option except to trade on that particular day and do with zero tracking errors.
Naturally, stocks that are to be dropped from an index are going to be under tremendous selling pressure (often at significantly reduced prices) while incoming index stocks are going to see a rise in prices due to an increase in demand.
The shareholder of an Index fund is destined to lose money on the depressed share prices of those leaving the index and the inflated prices on those being added to replace them.
The real problem for the index fund manager is that in order to achieve perfection and avoid random tracking errors his or her options are very limited. Irrationally, returns and performance aren’t the pure index fund manager’s objectives, zero tracking errors are.
This anomaly is known as the reconstitution effect, and clearly goes against what is typically an otherwise efficient system.
As an investor in index funds, this reconstitution effect is lager when the fund has fewer stocks. Therefore the effect would be lager with the DJ 50 and smaller for the S&P 500. To minimize the effect, use a very diverse fund such as the Vanguard Total Stock Market (VTSAX)
What is the Alternative?
What if fund managers did not have to buy and sell certain holdings on a given day? It’s likely that the savings would help the fund’s performance.
The alternative is to use non-index, low cost passively managed investment options such as those of Dimensional Fund Advisors, which is one of the fastest growing mutual fund families. The other alternative is some of the companies offering non-index and non-actively managed Exchange Traded Funds.