Several Aspects of Porfolio Rebalancing

Nowadays, many people looking to diversify their investment portfolios use different stock indexes. An index is a statistical tool that represents a group of securities, allowing investors to track the performance of a particular market segment or the market as a whole. Each company's weight in the index is typically proportional to its market capitalization. Investors use indexes to diversify because they offer exposure to a wide range of companies, thus reducing the risk associated with investing in individual stocks.

For example, the S&P 500 consists of 500 of the most valuable companies in the United States, and the Nasdaq-100 includes the top 100 non-financial companies listed on the Nasdaq exchange, mainly from the technology sector.

Despite the existence of many exchange-traded funds (ETFs) tracking such indexes (for example, SPY for the S&P 500 and QQQ for the Nasdaq-100), some investors may prefer to track these indexes on their own. One reason is to save on the management fees of these ETFs, though these fees are not typically very high.

Since the market capitalization of companies naturally changes, both the weighting of these companies in the indexes and the list of companies included can change over time as companies grow or shrink in size. As a result, investors may need to adjust their holdings by buying or selling shares of certain companies to align with the index.

This process is called rebalancing. In ETFs, rebalancing is carried out by fund managers, but when managing one’s own portfolio, it must be done by the investors themselves.

Indexes like the S&P 500 and Nasdaq-100 are rebalanced quarterly (for more information, see S&P Indexes and the Nasdaq Index Methodology). Therefore, investors should rebalance their portfolios once a quarter according to the new weights of the tracked index.

However, let us dive a bit deeper into rebalancing and examine the cases in which rebalancing happens.

Is Rebalancing Necessary at All?

Considering that each company's share in the index reflects its market capitalization, one might conclude that rebalancing is not necessary and that a portfolio mirroring the index will self-adjust. However, is this assumption valid in all cases? Let us explore this through several basic scenarios.

Imagine an index called SUPERTOP3 that tracks the three largest US companies by market value: Company A, Company B, and Company C. In all the following scenarios, we will use this example index. An investor allocated $10,000 to these companies according to their weights:

Scenario 1: Significant Growth in One Company

Company A experiences substantial growth, increasing its market capitalization by 50% to $750 billion. The other companies remain unchanged.

Portfolio adjustments:

• Company A’s investment grows by 50%: $5,000 × 1.5 = $7,500
• Company B and Company C remain at $3,000 and $2,000, respectively.
• New total portfolio value: $7,500 + $3,000 + $2,000 = $12,500

As a result, the investor has the following weights in their portfolio:

As we can see, the portfolio weights have adjusted automatically to match the new index weights without any rebalancing.

Scenario 2: Significant Growth in All Companies Except One

Company B and Company C both experience substantial growth, increasing their market capitalizations by 50% to $450 billion and $300 billion, respectively. Company A remains unchanged.

Portfolio adjustments:

• Company A’s investment remains at $5,000
• Company B’s investment grows by 50%: $3,000 × 1.5 = $4,500
• Company C’s investment grows by 50%: $2,000 × 1.5 = $3,000
• New total portfolio value: $5,000 + $4,500 + $3,000 = $12,500

As a result, the investor has the following weights in their portfolio:

Again, the portfolio weights have adjusted automatically to match the new index weights without any rebalancing.

Scenario 3: Changes in the Index Composition

Company C experiences a significant decrease in market capitalization by 50%, reducing it to $100 billion. At the same time, Company D increases its market capitalization to $200 billion. According to the rules of the index, which tracks the three largest companies by market value, Company C is replaced by Company D in the SUPERTOP3 index.

New index composition and market capitalizations:

The investor needs to adjust their portfolio to reflect the new index composition. This is not as simple as just selling Company C and buying Company D; the weights of Companies A and B have also changed in the index. Therefore, the investor must rebalance their holdings in all companies to match the new index weights.

Portfolio adjustments required:

• Sell holdings of Company C: Sell the entire position in Company C, now worth $2,000 × 0.5 = $1,000 (after a 50% decrease).

• Adjust holdings in Companies A and B: Sell a portion of holdings in Companies A and B to match the new index weights.

• Buy holdings of Company D: Use the proceeds from selling Company C and the amounts freed up from Companies A and B to purchase shares of Company D.

Resulting portfolio after rebalancing:

As we can see, rebalancing is required not only to replace Company C with Company D but also to adjust the holdings of existing companies to match the new index weights.

Conclusion

Therefore, in a market capitalization-weighted index with unchanged constituents, the portfolio naturally adjusts to reflect changes in market values, making rebalancing unnecessary when only market prices fluctuate.

When the index composition changes due to companies entering or exiting the index, rebalancing is required to ensure the portfolio accurately reflects the new index constituents and weights.

Disclaimers

This article is for informational purposes only and does not constitute financial advice. Investing involves risks, including the potential loss of principal. Before making any investment decisions, you should consult with a qualified financial advisor to consider your individual circumstances.

ChatGPT was used to assist in the writing of this article, but only as an editor and assistant.

Although I'm currently working as a Lead Backend Engineer at Bumble, the content in this article does not refer to my work or experience at Bumble.