Understanding Index Rebalancing and How it Works: Since the inception, indexes Sensex and Nifty have become one of the top indexes to watch not only in India but also globally. With the added boom in retail investor participation in the Indian markets post-pandemic, one can often hear queries for updates over the rise or fall of Nifty or Sensex over a cup of chai too! But a basic knowledge of the two is not enough to fully understand what they are.
While you might know the basic meaning of Nifty and Sensex, however, there are many activities related to the index which the newbies might not be aware of. One such activity is Index Rebalancing. Here, once in a while, the companies are being removed or added to the indexes, and whose news are heavily covered by the financial news websites.
In this article, we go through the concepts of Index Rebalancing and reconstitution of the indexes in order to understand them better. Keep reading to find out!
What are Indexes?
In simple terms, indexes are basically hypothetical portfolios created by the stock exchange which include only the top companies listed on the respective exchange. These companies are added to the indexes based on successfully meeting criteria already established. One such important criterion may be market capitalization. These criteria may vary depending on the index.
Indexes like Sensex and Nifty are extremely useful as they provide investors and companies with a reliable benchmark to compare and measure their performance with. For example, if the Sensex and nifty are going higher, it means that the market (or a broader level) is also going higher.
In addition to this these indexes also represent the country’s market and economy. Funds are even set up with their portfolios mimicking the indexes in an attempt to gain similar market returns.
What is Index Rebalancing and Reconstitution?
The index value is calculated through direct means or indirect means by adding weights.
As values like market cap keep changing based on the performance of the company so does the stock’s ability to meet the criteria set to remain a part of the index. This is where rebalancing and reconstitution come into the picture.
— Understanding Index Rebalancing
Creators of the Index like BSE and NSE also bear the responsibility to ensure that the composition of stocks in the index meets the criteria set beforehand.
Index Rebalancing refers to the process of readjusting the weights of the composition of index portfolios.
Now you must be wondering how regularly these indexes are rebalanced. There are no set rules for the time period within which indexes need to be rebalanced.
Most indexes have fixed schedules that they follow to rebalance their constituents. These however may vary from index to index.
The Nifty 50 Index rebalances its portfolio on March 31st and September 30th. BSE on the other hand revises the Sensex semiannually in June and December.
— What is Index Reconstitution?
Reconstitution is the process of changing the constituent securities of an Index. This reconstitution is done based on the stock’s ability to meet the criteria to be a part of the index.
Companies that meet the criteria like market cap are allowed to remain in the index. Companies that fall short are removed from the index and are replaced by other companies with larger market caps.
But the market cap of a company is largely dependent on the company’s performance and the market response to its security. However, the performance of a company is not the only aspect that may affect its stocks weight in the index or its ability to remain a part of the index. Other factors that may affect are:
- Delisting of a security: When a company is no longer listed on the stock market it also ceases to be a part of the index. Its weight is then redistributed among other companies with another company taking its place
- Merger and Acquisitions: When a company in the index merges or is acquired by another it once again ceases to be part of the index. Its weight is redistributed to the acquiring company. Another company which meets the required criterion takes its place and is weighed.
- Corporate Actions: Corporate action like stock splits or reverse stock splits are common in the market. Here the weights are accordingly adjusted to take into account the net effect of the corporate action.
Hypothetical: What happens if an Index is not Rebalanced or Reconstituted?
As we have seen above, indexes have various uses like acting as a benchmark or representing the economy of a country.
If the index only includes companies that used to meet its criterion once it becomes obsolete.
Nobody wants to compare their performance to companies that were part of the Sensex in 1986. They might even not exist anymore. Hence regular rebalancing and reconstitution are necessary to better reflect the Indian economy.
From the above, it is clear that companies being added, removed, and having their weights changed are part of their life in the stock market.
When it comes to investing it is not advisable to make decisions solely based on being part of the index or not. The stock may move upwards when it is reconstituted into the index. But this may be due to positive sentiments. But it is entirely possible that companies that are a part of the index may perform negatively.
That’s all for this post. Let us know what you think of this article on rebalancing and reconstitution of an Index and if you have any queries by commenting below. I’ll be happy to help. Happy Investing!
Aron, Bachelors in Commerce from Mangalore University, entered the world of Equity research to explore his interests in financial markets. Outside of work, you can catch him binging on a show, supporting RCB, and dreaming of visiting Kasol soon. He also believes that eating kid’s ice-cream is the best way to teach them taxes.