What is index rebalancing and why should you care about it?

This includes market-cap-weighted indexes, also known as capitalisation-weighted indexes, where each component stock is weighted according to its total market capitalisation, which represents the total market value of a company’s publicly traded shares.

Examples of market-cap-weighted indexes include the large-cap S&P 500 (VOO-NASQ) or the Russell 2000 (IWM-NASQ), which consists of small-cap companies.

Price-weighted indexes like the Dow Jones Industrial Average are more influenced by the stock prices of their components, based on criteria such as liquidity, financial viability, and sector representation, more than their market capitalisation.

When investing in any index, self-directed investors need to understand that these indexes are periodically adjusted in a process known as rebalancing.

Regular rebalancing is necessary to ensure the index accurately reflects the market’s prevailing performance and composition and meets its mandate or purpose and other specific criteria.

As such, an index provider periodically adds or removes stocks and may adjust the proportion of certain stocks in the index, known as their weighting.

For example, the S&P 500 is rebalanced quarterly, usually on the third Friday of March, June, September, and December. Other indexes are adjusted semi-annually or annually or may be adjusted ad hoc as market changes or developments necessitate.

These changes aim to reconstruct the index, ensuring it accurately represents the particular market, sector or region it tracks.

Without regular rebalancing, an index could slowly diverge from its initial market representation due to various factors, such as rising or falling market capitalisation due to changing stock prices, or as companies delist, merge with others, pivot their core business focus, or declare bankruptcy.

For instance, in September 2024, the S&P 500 experienced its most significant rebalancing since 2020 as the weighting of Broadcom Inc. (AVGO-NASQ) and Amazon (AMZN-NASQ) shares increased while Palantir Technologies Inc. (PLTR-NASQ) and Dell Technologies joined the large-cap index due to significant increases in their respective market caps.

However, increasing market capitalisation can also impact the stock’s weighting in an index. For example, three of the world’s biggest companies had their influence reduced in the tech-heavy Nasdaq 100 Index after the tech rally of 2024 swelled their market caps to unprecedented size.

Tesla (TSLA-NASQ)., Meta Platforms (META-NASQ) and Broadcom Inc. (AVGO-NASQ) all saw their share of the benchmark fall in an annual rebalancing that happened in December 2024. In contrast, Apple (AAPL-NASQ), Nvidia Corp. (NVDA-NASQ), Microsoft (MSFT-NASQ) and Alphabet Inc. (GOOG-NASQ) all emerged from the annual process with larger weights, according to data compiled by Bloomberg.

This happened because the Nasdaq 100 is weighted roughly according to its members’ relative market caps but is also governed by several provisions that can take effect when companies become too big, which triggers a reweighting.

Rebalancing also ensures an index adapts to economic and sector shifts. For example, in its March 2024 rebalancing, the S&P 500 added Super Micro Computer (SMCI-NASQ) to the index, replacing Whirlpool (WHR-NASQ).

Self-directed need to understand index rebalancing as it can significantly impact your investments by potentially increasing concentration risk or it may diverge from your defined investment strategy.

For instance, an index could shift its focus from growth stocks to value-oriented companies, which may no longer suit your long-term investment strategy. In these cases, an investor may need to reconsider their choice of index and look for alternative index-tracking funds that better match their long-term goals.

Changes to an index may also shift the composition of an overall investment portfolio, potentially making it overly concentrated. This can happen when a sector or a few large companies begin to dominate, which happened with the tech sector in 2024.

While this shift can increase risks within a portfolio, a rebalancing event can also create opportunities for traders. When index providers add stocks to an index, these listed companies typically experience a rise in share price due to significant shifts in trading volumes, which can affect stock prices, sector trends, and broader market sentiment. 

In contrast, stocks removed from an index may lose value, creating potential opportunities for short-selling. As such, savvy traders can leverage these fluctuations to profit from these short-term market movements, although it’s essential to approach this strategy with caution and thorough analysis.

Understanding index rebalancing can arm you with the knowledge needed to improve how you navigate the investment landscape. Whether you’re a self-directed investor or a do-it-yourself (DIY) trader, knowing how and why indexes are rebalanced can help you make more informed decisions that align with your financial goals.