Most investors understand that index funds don’t simply passively own “the market”. The composition of the underlying indices these funds track is not fixed; it evolves continuously as companies are removed and replaced. Each year, numerous firms exit various indices, making way for new additions. This turnover is especially pronounced during market disruptions, such as the 2007-2008 financial crisis, when the portfolio of a broad market index investor can shift dramatically in a short time.
Since most equity indices are market-cap weighted (or more precisely, float-adjusted market-cap weighted), the weightings of individual constituents are constantly shifting. Rob Arnott of Research Affiliates has even argued that investing in market-cap weighted indices is essentially a “growth-tilted, momentum-chasing, active strategy” rather than true passive investing.
When conducting fundamental historical index analysis or backtesting, it’s crucial to account for how index constituents have changed over time. Failing to do so can lead to survivorship bias, where analysis is based on the current index members rather than the full set of historical constituents. If your backtests do not include the complete stock universe, the validity of your trading strategy’s historical performance may be called into question.
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How & by whom are equity index components selected?
There are two main approaches how constituents of an equity index are determined.
The first approach is a strict rule-based method. The most important criteria for index inclusion is generally the market value of a company but there are almost always other criteria too. For most U.S. indices, the companies need to be headquartered in U.S. so just listing shares on the NYSE or the NASDAQ does not automatically guarantee that a stock is eligible for all indices. Another common criterion is that if too many shares of a certain company are held by a very small number of individuals/institutions, the company won’t be considered for inclusion.
The second approach is that an index committee has a responsibility of maintaining an index and the committee makes the final decisions of which companies are removed and added and when the changes will happen. The committee needs to follow the general index inclusion guidelines but still has a certain degree of autonomy to select the constituents as they see fit.
How often are index components changed?
Most indices are rebalanced on a regular basis, typically once per quarter and once per year. Companies that do not fulfill the index inclusion criteria anymore, usually because their market value has significantly decreased, are removed from an index and replaced with new companies.
In the case of mergers and acquisitions etc., the changes to the constituents can also happen outside of the rebalancing dates. It depends on the index rules whether the number of index constituents is fixed. For most indices, when an existing index constituent is e.g. acquired by an competitor, the acquired company is replaced with another company at the same exact time when the original constituent is removed.
However, this is not always the case. For example, the Russell 3000 index does not include exactly 3000 constituents. At the moment, the index includes only 2855 components (2/28/2021). When current index companies are delisted, the numbers of constituents of the Russell 3000 index is temporarily reduced and will be increased again during the next rebalancing.
Sometimes index component changes can have a major effect for the portfolios of index funds. When Tesla was added to the major U.S. indices, most index funds needed to make large changes to their holdings.
How are index components weighted?
The index weight methodology defines how the weightings of each index component is calculated.
The most common approach is to follow the market cap weighted method. This means that a company’s market value defined how much the change in the stock price of a company affects the price level of the whole index. For most indices, there exists also an equal weighted version in which every single constituent has exactly the same weighting. This means that the price movements of smaller companies have the same effect as the price increases/decreased of the larger companies.
Most of the major indices are also adjusting the market values of the companies by the number of shares that is not generally available for the public market. For example, a large amount of stocks can be owned by certain institutions and individuals (usually founders or the families of the founders) who are holding their shares for the long-term. These shares are excluded when the so called free-float adjusted market cap is calculated for index components.
At the moment, most U.S. indices tracking the market as whole are dominated by the large tech companies. For most trading days, the price movements of the FAANG stocks (Facebook, Apple, Amazon, Netflix, Google/Alphabet) and Tesla largely determine the direction of the whole index.
Does inclusion to an index affect the price of a stock?
Many studies have concluded that an addition to a major equity index has a positive impact for a company’s share price. For example, Anthony W. Lynch from New York University and Richard R. Mendenha from University of Notre Dame have proved a positive abnormal return for shares added to the main U.S. stock index of about 3.8% over the period starting the day after the announcement and ending the day before the effective date of the change. Their data also shows that deletion from the index causes significant post-announcement decrease in stock prices.
The simple explanation for this phenomenon is the dominance of passive investing. Mutual funds and exchange traded funds will buy the stocks that are added to an index and sell stocks that are removed. Index inclusion can also make retail investors more aware of a specific company, thus increasing retail buying.
Also, more complicated explanations for the positive price effect have been suggested. Petya Platikanova from Ramon Llull University has suggested that discretionary accruals (non-obligatory expense, e.g. future bonus for management, that is yet to be realized but is already recorded in the account books) significantly decrease after companies are added to an major index, which greatly improves earnings quality.
Many companies have multiple different share classes outstanding. Typically, the main difference between various share lines are voting rights: there is a specific share class does not have any voting rights (or considerable reduced number of votes) at the annual shareholder meeting and another share class that provides the full number of votes. This is especially common with technology companies. The founders do not want to lose their decision-making power after publicly listing their companies so most of the shares offered for the public do not have voting rights.
Equity indices have adopted different approaches of how to treat companies with many share lines. Many indices include all share classed of a company if each of the share classes fulfill the inclusion criteria. Some indices are still accepting just a single share line of a company.