Reconstitution: Meaning, How it Works, Effect on Investors

What Is Reconstitution?

Reconstitution involves the re-evaluation of a market index. The process involves sorting, adding, and removing stocks to ensure that the index reflects up-to-date market capitalization and style.

Understanding Reconstitution

An index fund, a subset of mutual funds or ETFs, has a portfolio that, by design, tracks the components of an established market index. The Russell indexes are a well-known example of a stock exchange that goes through an annual reconstitution.

When considering the Russell Index, all publicly traded stocks ranked in order by market capitalization form the basis of the annual reconstitution. New indexes are further shaped by separating out stocks that have become ineligible and adding newly ranking stocks. The Russell indexes are influential enough that other index funds track them, so the Russell reconstitutions tend to have a direct and immediate impact, changing the constitution of various other index funds, which affects prices and investor holdings. Other indexes tracked by index funds include the Dow Jones Industrials, Standard & Poor's 500 Index (S&P 500), and the NASDAQ 100.

The reconstitution process for the Russell 3000 works as follows between May and June of a given year: Rank Day occurs early in May, which is when a preliminary list of the largest 4,000 publicly traded stocks are ranked and assessed. The end goal is determining which of these will make the reconstituted Russell 3000 Index.

Later, in early June, FTSE Russell posts preliminary changes to the list on its website. A week later, FTSE Russell posts an updated version of this membership list. A week after that, the final reconstituted indexes go into effect at the close of market day and are traded at the open of the next trading day.

The Effects of Reconstitution for Investors

The process of reconstitution is an efficient way of reflecting changing investor confidence in companies represented on these lists. With their public notifications over a series of weeks, indices give investors and traders a heads up on the companies that will move to and from their respective indices.

Since the stocks of the companies affected may see a huge uptick in buying or selling, there is potential for the investor to take quick advantage of these changes and potentially make a quick profit.

Yet an investor in index funds must remember that index managers need to buy the additions and sell the exclusions according to this reconstitution and nothing else; they do not make these changes based on the performance of the stock but rather to match the reconstituted index the fund tracks.

The reconstitution effect, then, means that securities added to the index will typically have greater purchase demand, raising prices, and for the index’s deletions, declining prices. So the index generally adds securities at higher prices and deletes securities at lower prices than it would have if no assets had been tracking it because index managers seek liquidity on or near the index reconstitution date.

But afterward, index managers no longer feel these liquidity demands, and so the price effect generally goes into a reversal, with an index’s additions underperforming and deletions outperforming. This can negatively impact performance on all funds tracking these indices.