What is Index rebalancing? Why and how is it done and what is its impact on the stock market?

Do you know Nifty50? Obviously, you do! It has 50 stocks, but do you know that the 50 companies in the index keep changing. The change happens through an index rebalancing process, which means that some stocks come out and some replace them. There is more to it. Let us look at the details.

Meaning of Index Rebalancing

Index rebalancing refers to the periodic adjustment of the constituents of an index to ensure that it accurately reflects the market's current composition and performance. It is essential for maintaining the integrity and representativeness of the index, ensuring that it accurately reflects the underlying market dynamics and investor sentiment. 

Too technical? Let us understand rebalancing with an example. Imagine you are asked to form a cricket team to compete in a tournament. You want to ensure that the team remains competitive and well-balanced throughout the season. Just like an index is initially created with a set of constituents, you begin by selecting players for your cricket team based on their skills, experience, and performance. You aim to include a diverse mix of players representing different positions to cover all aspects of the game.

As the cricket season progresses, you closely monitor each player's performance and the team. Similarly, index providers continuously track the performance of index constituents, considering factors like player form, injuries, and team dynamics. You analyze your team's performance to identify strengths and weaknesses in different areas, such as batting, bowling, fielding, and team strategy. Similarly, index providers assess the performance of index constituents and sectors to identify areas of strength and weakness in the market. 

Based on your analysis, you may decide to change your cricket team to address any weaknesses or capitalize on emerging opportunities. For example, if you notice a lack of spin bowlers in your team, you might recruit a talented spinner to balance the bowling attack. Similarly, index rebalancing involves adding or removing index constituents and adjusting their weights to maintain balance and representativeness.

Why is it important to rebalance the index?

Here is why index rebalancing is important:

• Reflecting Market Dynamics: Index rebalancing ensures that the index accurately reflects the current state of the market. As market conditions change, including shifts in market capitalization, liquidity, and sector performance, it is crucial to adjust the index constituents and weights to maintain relevance and representativeness.
• Maintaining Objectivity and Transparency: Index rebalancing helps preserve the objectivity and transparency of the index construction process. By following predefined criteria for selecting and weighting index constituents, index providers can avoid biases and ensure consistency over time, enhancing investor trust and confidence.
• New Listing: Many new companies get listed on the NSE. Also, existing companies may be delisted or merged with other companies, which can impact the index. Rebalancing the index allows for these changes to be reflected in the index.
• Alignment with Investment Objectives: Index rebalancing ensures that the index remains aligned with its stated investment objectives and methodology. Whether the index aims to represent a specific market segment, sector, or investment strategy, regular rebalancing helps uphold the integrity and relevance of the index in achieving its intended purpose.

How is index rebalancing done?

Index rebalancing is a complicated process that involves several steps. Let us look at how index balancing is done:

Initial Review: The first step in the process is to gather the information and data of all the companies - the existing companies in the index and the potential companies that may get included.

Setting the Criteria: Inclusion and exclusion involves different criteria. In this step, these criteria are decided. For example, it may be decided that companies with a market cap of X crore can only become part of the Nifty Mid Index. So, even if a particular company satisfies other criteria but misses this basic one, it will not be included. Another important criterion that is set is to include companies from various sectors in the index for diversification. 

Inclusion and Exclusion: Based on the criteria set, a list of potential candidates who may get entry into the index is made. At the same time, companies that may have exits are decided. The review committee reviews the changes and confirms the changes align with the index's objective. After the review process, the companies to be added and removed are prepared.

Balancing the index: Other than inclusion and exclusion, the companies' weights are also looked at in the rebalancing process. Based on the pre-decided method, the weight of each company in the index is decided.

Implementation: The final step in the rebalancing process is announcing the changes a few days or weeks in advance. On the date of the change, make the required changes.

A Recent Example

The rebalancing happens every six months. In the September 2023 review cycle, there was no change in the Nifty50 index (in terms of names). However, other Nifty indices saw the addition and deletion of stocks. For example, Nifty Next 50 saw five stocks getting removed - ACC, Nykaa, HDFC AMC, Indus Tower, and Page Industries. The companies that replaced them were PNB, Shriram Finance, Trent, TVS Motors, and Zydus Lifesciences.

Impact of rebalancing on the stock market

Let us look at the impact of rebalancing on the stock market. Index rebalancing happens periodically, so you should know the impact.

Rebalancing in the stock market can have significant impacts on individual stocks and broader market indices. When indexes undergo rebalancing, they buy or sell shares of the underlying stocks to align their portfolios with changes in the index composition. It can lead to increased trading activity, volatility in the affected stocks, and potential price movements that ripple throughout the market. 

Additionally, rebalancing may result in shifts in sectoral weights and market capitalization within indices, influencing investor sentiment and market trends. 

What does index rebalancing mean for investors?

Index rebalancing holds several implications for investors, impacting their investment strategies, portfolio performance, and risk management approaches. Firstly, for investors holding index-tracking funds (ETFs), index rebalancing directly affects their portfolio composition. As index providers adjust the weights and constituents of the index, fund managers must realign their portfolios accordingly. 

Second, index rebalancing events often prompt increased trading activity in the affected securities, leading to short-term price fluctuations. Investors need to be aware of these fluctuations and understand that they may not necessarily reflect the intrinsic value or fundamentals of the underlying companies.

Third, for long-term investors, there is no impact on the short-term. However, in the long term, there could be an impact. For example, over time, the index shifts its focus. Assume you invested in index ABC, as it has a higher allocation to value-oriented companies. However, with time, growth-oriented companies become part of it. It may no longer be suitable for you.

Before you go

Index rebalancing can have implications for portfolio management and investment strategies. Changes in index constituents and weights may impact the performance of index-tracking funds and ETFs and the performance of actively managed funds that use the index as a benchmark. Therefore, investors need to stay informed about index rebalancing events and adjust their investment strategies accordingly.