How Does Annual Rebalancing Impact Investors Who Track an Index?

Russell indices recently underwent their annual summer reconstitution event. This is when additions and deletions are made to the list of constituents in accordance with the rules of the indices. What happens in between these arbitrary points on the calendar? Imagine skipping lawn mowing duty for a few months and you’ll get the picture.

Over the past five years, the Russell 1000 Value Index’s reconstitution day turnover has been between 12% and 17% (see Exhibit 1).¹ Abnormally high trading volume is a potential indication that demanding immediacy to trade in such stocks in the same direction may be costly. 

Exhibit 1: Daily Turnover for the Russell 1000 Value Index
January 2019–June 2023

¹Turnover figures calculated by Dimensional using daily index holdings data. For each trading day, Dimensional calculates the difference in the weight of each holding at the market close of that day and on market open of the following day. In addition to reconstitution events, index holdings are impacted by corporate actions (dividends, mergers/acquisitions, spin-offs, etc.) and IPOs.

 Frank Russell Company is the source and owner of the trademarks, service marks, and copyrights related to the Russell Indexes. Indices are not available for direct investment.

This price pressure does not have to manifest itself all on the day of reconstitution. 

Our research has shown that market prices are forward-looking. Thus, because index rebalances are announced before the reconstitution date, an approach that is constrained to rebalance on the same day as an index may suffer from price pressure well ahead of the reconstitution date. Indeed, our research shows that stocks added to an index often tend to outperform their respective indices prior to rebalancing, while stocks deleted from an index can tend to underperform (see Exhibit 2).

Exhibit 2: Average Cumulative Excess Returns of S&P 500 Additions and Deletions
2015–2019

Past performance is no guarantee of future results. In USD. Notes: Daily excess returns are calculated as the equal-weighted average of individual security returns minus the respective index returns. The cumulative excess return for day t+1 is calculated as the sum of the daily equal-weighted average excess return from t–22 for S&P, where t+0 is the reconstitution date. S&P data © 2023 S&P Dow Jones Indices LLC, a division of S&P Global. All rights reserved. 

Concentrated turnover also causes portfolio characteristics to drift from the intended objective. Based on the turnover levels in Exhibit 1, managers tracking the Russell 1000 Value were investing between one-eighth and one-fifth of their cash flows into stocks no longer considered large value by Russell.  

An investment process with the flexibility to rebalance continuously through time can maintain asset class exposures more consistently (potentially capturing premiums more reliably) and potentially avoid unnecessary costs.

Sources: Dimensional Fund Advisors