MONEY LEFT ON THE TABLE - PASSIVE INVESTING AND THE EFFECTS OF RECONSTITUTION - White Paper 26 August 2020 Research, Solactive AG
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Money Left on the Table – Passive Investing and the Effects of Reconstitution
MONEY LEFT ON THE TABLE –
PASSIVE INVESTING AND THE
EFFECTS OF RECONSTITUTION
White Paper
26 August 2020
Research, Solactive AG
1Money Left on the Table – Passive Investing and the Effects of Reconstitution
TABLE OF CONTENTS
Executive Summary ............................................................................................................................................................................................................... 3
Highlights of the Paper ................................................................................................................................................................................................... 3
Why the Current Situation is Far From Ideal? ............................................................................................................................................................... 3
How We Examine the Issue .................................................................................................................................................................................................. 4
Measuring the Impact of Reconstitution .................................................................................................................................................................. 4
Our Index Simulations ..................................................................................................................................................................................................... 5
Historical Observations......................................................................................................................................................................................................... 5
A Significant Magnitude of Impact ............................................................................................................................................................................. 5
What Exactly Makes the Impact? ................................................................................................................................................................................ 6
Significant Impact – Conclusion ........................................................................................................................................................................................ 6
References ................................................................................................................................................................................................................................ 7
Appendix ..................................................................................................................................................................................................................................... 7
Disclaimer.................................................................................................................................................................................................................................. 8
Contact ....................................................................................................................................................................................................................................... 9
2Money Left on the Table – Passive Investing and the Effects of Reconstitution
EXECUTIVE SUMMARY more attention from market participants. By
anticipating the upcoming changes in the
In this paper, we seek to address the impact of underlying indices, market participants buy (sell)
reconstitution that index trackers suffer at the time expected additions (deletions) much before the
of reconstitution. We observed material excess announcement from the index providers. As a result
return from advance reconstitution across of such trades, index funds suffer from buying
different months of a year and in various size (selling) at a relatively higher (lower) price around
segments, attributing to not only stock the index reconstitution date. This negative impact
additions/deletions but also to pure weight of trading beforehand is what we call the hidden
changes of the components of the underlying index. ‘Impact of Reconstitution’ at the cost of closely
Therefore, highly cost-conscious index investors tracking the index.
should reckon with this impact of reconstitution as
it generates a noteworthy drag on performance. Former researches found an implicit cost of more
than 20 basis points annually from advance
buying/selling of additions/deletions with the US
HIGHLIGHTS OF THE PAPER large-cap stock index [Reference 2] and 12-36 basis
Based on our simplistic model that measures the points with the European blue-chip index
impact of reconstitution as the excess return of a [Reference 3], which cannot be disregarded.
hypothetical portfolio that reconstitutes in Nevertheless, if stock additions and deletions are
advance of the underlying index, we observed: predictable, the weight changes of other
compositions of the indices also follow naturally.
historically, the impact of reconstitution was An investigation into a world index showed that the
statistically significant in the majority of overall performance drag amounted to 44 basis
months for all size segments with four-week points annually in the wake of advanced trading
advance reconstitution of the hypothetical [Reference 4].
portfolio
large-cap segment exhibited the lowest impact As a periodic rule-based re-evaluation of the
of reconstitution whereas the small-cap market index, reconstitution is distinguished from
segment had the highest impact general rebalancing, which also reflects a wider
scope of weight adjustments owing to corporate
apart from stock additions and deletions, pure actions, etc. In this paper, we mainly focus on
weight changes of the other constituents also regular index reconstitution instead of broader
caused a material impact on the reconstitution rebalancing practices. We first define a simple
of the underlying index model for evaluating the impact of reconstitution.
We then study the magnitude of impact and show a
WHY THE CURRENT SITUATION IS FAR
comparison across reconstitutions in different
FROM IDEAL?
months of a year and various size segments. Finally,
The proverb, “the early bird catches the worm,” is we present the attribution of this impact from
relevant in financial markets as well. Investors stock additions/deletions and weight changes of
today compete relentlessly to be at the forefront, other components of the underlying index.
digging out every chance of profit-making ahead of Although taxes and transaction costs are also
their peers. With passively managed funds taking significant in the context of reconstitution, we will
up half of the market [Reference 1], the not delve into those costs since a simple
reconstitution of the underlying indices leading to generalization is not indicative of the precise costs,
massive turnover in the capital market is gaining which can vary substantially for different funds.
3Money Left on the Table – Passive Investing and the Effects of Reconstitution
HOW WE EXAMINE THE ISSUE WR = Reconstituted weight of the stocks in the
There are two parts to this section. In the first part, underlying index at the actual index
we describe how we measure the impact of reconstitution date
reconstitution. In the second part, we illustrate WC = Close weight of the stocks in the underlying
various indices we simulated historically to study index N days before the actual index
the impact in detail for each month of a year in each
reconstitution date
size segment.
RS = Return of the stocks in those N days
MEASURING THE IMPACT OF
RECONSTITUTION
The impact of reconstitution can be dissected into
We assume a hypothetical portfolio tracks the four different components: excess return from
index all-round the year, but it reconstitutes in stock additions/deletions and excess return from
advance of the actual underlying index pure weight changes (see Exhibit 1).
reconstitution. Due to this advance reconstitution, Mathematically, these components of the impact
the hypothetical portfolio will generate an excess can be expressed as follows:
return. We measure this excess return and call it
the ‘Impact of Reconstitution’. Ideally, it is desirable Stock Additions = ∑(WR − WC )R s ∀ WC = 0
to have a very low impact on reconstitution.
In our simplistic model, there are three underlying Weight Increases = ∑(WR − WC )R s ∀ WR > WC
assumptions. First, the portfolio manager of the
∑(WR − WC )R s
hypothetical portfolio can predict the upcoming Weight Decreases = ∀ WR < WC
changes in the index with 100% accuracy and can
Stock Deletions = ∑(WR − WC )R s ∀ WR = 0
trade the desired quantity of shares at the closing
price on any given day. Second, on the actual
reconstitution date of the underlying index, the
Exhibit 1: Components of Excess Return due to Advance
portfolio manager will match the index weights to
Reconstitution of the Hypothetical Portfolio
have zero tracking error after the index has
reconstituted. Third, the hypothetical portfolio
manager incurs no other costs, such as transaction Stock Additions
Impact of Reconstitution
costs or taxes.
(Excess Return)
Weight Increases
If the above assumptions hold true, and the
hypothetical portfolio reconstitutes ‘N’ days before Weight Decreases
the actual index reconstitution, then the excess Stock Deletions
return or the impact of reconstitution will be equal
to the sum of the difference in the hypothetical
portfolio and the index security weights multiplied
by the respective security return in those N days.
Mathematically, it can be written as follows:
Index Hypothetical Portfolio
Impact of Reconstitution = ∑(WR − WC )R s
Source: Solactive. Chart is provided for illustrative purposes.
where:
4Money Left on the Table – Passive Investing and the Effects of Reconstitution
OUR INDEX SIMULATIONS business on the third Friday of July, October, and
January each year.
We formed the universe of US companies for our
historical simulations in two steps. First, we took all We also calculated an average index for each size
the companies headquartered and incorporated in segment by taking the average of the index levels of
the US and listed on NYSE and/or NASDAQ. Second, each monthly index belonging to the respective size
we excluded the companies ranking within the segment to measure the average impact of
bottom 2.5% of by cumulative market reconstitution. For example, the Large-Cap
capitalization coverage from step one, to avoid the Average index was the average of all the 12 monthly
inclusion of very small companies. While excluding Large-Cap indices.
the bottom 2.5% companies, we also applied a We calculated the weekly index total returns from
buffer of 0.5% to prevent excessive turnover of the December 27, 2002, to December 27, 2019, for all
small cap companies. our analysis throughout this paper.
We defined the size segments based on the We would like to acknowledge that various
companies’ cumulative market capitalization rank permutations and combinations, of cumulative
within the universe formed above. The top 70% weight cutoff limits for the initial universe, size
were classified as large-cap. The next 15% were segments, buffers, as well as the dates of
categorized as mid-cap, and the last 15% were reconstitution and selection, are possible, and
grouped into small-cap companies. While could be a subject of exploration in future research
classifying the companies into size segments, we studies.
applied a buffer of 2.5% to prevent excessive
turnover within the size segments. The application HISTORICAL OBSERVATIONS
of buffers is a very common method for controlling
In this section, we present the magnitude of the
excessive turnover.
impact of reconstitution and present the
To measure the impact of reconstitution in attribution from stock additions/deletions and pure
different months and size segments, we calculated weight changes of other components of the
12 x 3 = 36 indexes representing each month of a underlying index.
year for each size segment. The indices were
A SIGNIFICANT MAGNITUDE OF IMPACT
reconstituted annually after the close of business
on third Friday of the respective index month with Historically, we observed the impact of
the selection date as last the trading date of the reconstitution became statistically significant in
previous month. The indices were also adjusted for the majority of months for all the size segments
float changes after the close of business on the when the hypothetical portfolios reconstituted
third Friday of every the third, sixth, and ninth four weeks before the actual reconstitution of the
month from their respective annual reconstitution underlying indices (see Exhibit 2).
month. All the indices were float market Shorter advance reconstitution periods also had
capitalization weighted. some impact, but the magnitude was not
statistically significant for the majority of the
For example, the April Mid-Cap index was
hypothetical portfolios (see Exhibits 4, 5, and 6).
reconstituted after the close of business on the
third Friday of April each year, with the selection Therefore, market participants who acted early
date as of the end of March each year, respectively. impacted the reconstitutions of the underlying
It was adjusted for float changes after the close of indices considerably.
5Money Left on the Table – Passive Investing and the Effects of Reconstitution
Exhibit 2: Annualized Impact of Reconstitution when Exhibit 3: Attribution of Average Annualized Impact of
Hypothetical Portfolio Reconstituted Four Weeks Before Reconstitution when Hypothetical Portfolios
Actual Underlying Index Reconstitution Reconstituted Four Weeks Before Their Actual Underlying
Index Reconstitution
Large-Cap Mid-Cap Small-Cap
Stock Deletions Weight Decreases
Jan
Weight Increases Stock Additions
Feb
50.0
Impact of Reconstitution in Basis Points
Mar
Apr
May 12
25.0
15
Jun 3
15
Jul 10
7 9
Aug 2 5
0.0
Sep -7
-12
-1
Oct
Nov -25.0
Dec
-50.0 -25.0 0.0 25.0 50.0
Impact of Reconstitution in Basis Points -50.0
Large-Cap Mid-Cap Small-Cap
Statistically significant (p-value < 5%)
The annualized Impact of Reconstitution was calculated by subtracting The annualized Impact of Reconstitution was calculated by subtracting
the annualized total return of the underlying index from the annualized the annualized total return of the underlying index from the annualized
total return of the hypothetical portfolio over the entire back-tested total return of the hypothetical portfolio over the entire back-tested
period. period. The attribution was also calculated by cumulating the excess
Source: Solactive and FactSet. Data from December 27, 2002 to December return from stock addition/deletion and pure weight changes over the
27, 2019 in USD. Chart is provided for illustrative purposes. Past entire back-tested period.
performance is no guarantee of future results. Source: Solactive and FactSet. Data from December 27, 2002 to December
27, 2019 in USD. Chart is provided for illustrative purposes. Past
performance is no guarantee of future results.
WHAT EXACTLY MAKES THE IMPACT?
SIGNIFICANT IMPACT – CONCLUSION
Although the stock additions/deletions impacted
the reconstitutions of the underlying indices In this paper, we attempted to study the impact of
substantially over a longer advance reconstitution reconstitution across different months of a year
period, pure weight changes of the other and in various size segments. We defined the
components also created material impact (see impact of reconstitution as the excess return that a
Exhibit 3). The Large-Cap segment had the lowest hypothetical portfolio will generate if it
impact, while the small-cap segment had the reconstitutes in advance of the actual underlying
highest impact. On average, stock deletion led to a index reconstitution.
reduction in the impact of reconstitution over We observed the impact of reconstitution became
longer lookback periods across all the size significant in the majority of months for all the size
segments in our sample data. segments when the hypothetical portfolios
The average impact in Exhibit 3 was calculated and reconstituted four weeks before the actual
attributed to stock additions/deletions and pure reconstitution of the underlying indices. Therefore,
weight changes of other components using the market participants, who acted early, created a
average index of each size segment. considerable impact on the reconstitutions.
6Money Left on the Table – Passive Investing and the Effects of Reconstitution
We further noticed that apart from stock APPENDIX
additions/deletions, pure weight changes of the
The upper limits of the magnitude of impact of
other components also created material impact on
reconstitution over one-week advance
the reconstitution of the underlying index.
reconstitution period were 8, 10, and 6 basis points
Since the impact of reconstitution can have a for large-, mid-, and small-cap segments,
sizeable effect on the performance of the respectively (see Exhibit 4).
underlying index, ways to lower it could be explored Exhibit 4: Annualized Impact of Reconstitution when
as a future research topic. Hypothetical Portfolio Reconstituted One Week Before
Actual Underlying Index Reconstitution
REFERENCES
Large-Cap Mid-Cap Small-Cap
[1] Morningstar Fund Flows August 2019
Jan
https://www.morningstar.com/content/da Feb
m/marketing/shared/pdfs/Research/Fund Mar
_Flows_August2019_Final.pdf? Apr
[2] The Hidden Costs of Index Tracking – May
Winton Jun
https://www.winton.com/research/the- Jul
hidden-costs-of-index-tracking Aug
Sep
[3] Index Turnover Costs – Solactive Research
Oct
https://www.solactive.com/wp- Nov
content/uploads/2018/04/Solactive-Index- Dec
Turnover-Costs.pdf
-50.0 -25.0 0.0 25.0 50.0
[4] The Index Effect in Factor Benchmarks – Impact of Reconstitution in Basis Points
PGGM
Statistically significant (p-value < 5%)
https://www.pggm.nl/media/z5gfn4gh/the The annualized Impact of Reconstitution was calculated by subtracting
the annualized total return of the underlying index from the annualized
sis_vba_rk_final.pdf total return of the hypothetical portfolio over the entire back-tested
period.
Source: Solactive and FactSet. Data from December 27, 2002 to December
27, 2019 in USD. Chart is provided for illustrative purposes. Past
performance is no guarantee of future results.
7Money Left on the Table – Passive Investing and the Effects of Reconstitution
The upper limits of magnitude of impact of The upper limits of magnitude of impact of
reconstitution over two-week advance reconstitution over three-week advance
reconstitution period were 10, 19, and 12 basis points reconstitution period were 9, 19, and 19 basis points
for large-, mid-, and small-cap segments, for large-, mid-, and small-cap segments,
respectively (see exhibit 5). respectively (see Exhibit 6).
Exhibit 5: Annualized Impact of Reconstitution when Exhibit 6: Annualized Impact of Reconstitution when
Hypothetical Portfolio Reconstituted Two Weeks Before Hypothetical Portfolio Reconstituted Three Weeks Before
Actual Underlying Index Reconstitution Actual Underlying Index Reconstitution
Large-Cap Mid-Cap Small-Cap Large-Cap Mid-Cap Small-Cap
Jan Jan
Feb Feb
Mar Mar
Apr Apr
May May
Jun Jun
Jul Jul
Aug Aug
Sep Sep
Oct Oct
Nov Nov
Dec Dec
-50.0 -25.0 0.0 25.0 50.0 -50.0 -25.0 0.0 25.0 50.0
Impact of Reconstitution in Basis Points Impact of Reconstitution in Basis Points
Statistically significant (p-value < 5%) Statistically significant (p-value < 5%)
The annualized Impact of Reconstitution was calculated by subtracting The annualized Impact of Reconstitution was calculated by subtracting
the annualized total return of the underlying index from the annualized the annualized total return of the underlying index from the annualized
total return of the hypothetical portfolio over the entire back-tested total return of the hypothetical portfolio over the entire back-tested
period. period.
Source: Solactive and FactSet. Data from December 27, 2002 to December Source: Solactive and FactSet. Data from December 27, 2002 to December
27, 2019 in USD. Chart is provided for illustrative purposes. Past 27, 2019 in USD. Chart is provided for illustrative purposes. Past
performance is no guarantee of future results. performance is no guarantee of future results.
DISCLAIMER
Solactive AG does not offer any explicit or implicit guarantee or assurance either with regard to the results of using an Index
and/or the concepts presented in this paper or in any other respect. There is no obligation for Solactive AG - irrespective of
possible obligations to issuers - to advise third parties, including investors and/or financial intermediaries, of any errors in an
Index. This publication by Solactive AG is no recommendation for capital investment and does not contain any assurance or
opinion of Solactive AG regarding a possible investment in a financial instrument based on any Index or the Index concept
contained herein. The information in this document does not constitute tax, legal or investment advice and is not intended as a
recommendation for buying or selling securities. The information and opinions contained in this document have been obtained
from public sources believed to be reliable, but no representation or warranty, express or implied, is made that such
information is accurate or complete and it should not be relied upon as such. Solactive AG and all other companies mentioned
in this document will not be responsible for the consequences of reliance upon any opinion or statement contained herein or
for any omission.
8Money Left on the Table – Passive Investing and the Effects of Reconstitution
CONTACT
Solactive AG Timo Pfeiffer
German Index Engineering Head of Research & Business Development
Platz der Einheit 1 Tel.: +49 (0) 69 719 160 320
60327 Frankfurt am Main Email: timo.pfeiffer@solactive.com
Germany
Tel.: +49 (0) 69 719 160 00 Utkarsh Agrawal
Fax: +49 (0) 69 719 160 25 Vice President Research
Email: info@solactive.com Email: utkarsh.agrawal@solactive.com
Website: www.solactive.com
© Solactive AG Fabian Colin
Head of Sales
Tel.: +49 (0) 69 719 160 220
Email: fabian.colin@solactive.com
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