Rearrange

The movements of indices like the S&P 500 and Nasdaq ($NDAQ) are often seen as a reflection of the overall health of the stock market, as a snapshot. The value of these groupings of shares regularly goes up and down, with daily figures being in the green or red. Sometimes there’s a longer term trend in one direction, but there can also be periods of no real change. 

While these benchmarks are well-established structures, they aim to capture a dynamic market. To account for change, the list of companies comprising an index requires regular updates. However, rebalancing an index is not as simple as hitting the refresh button. 

With the S&P 500 including the 500 largest U.S.-listed stocks by market capitalisation, its components and their sizes are expected to naturally shift over time. In its next quarterly reshuffle coming up on 24 June, CrowdStrike ($CRWD), KKR & Co. ($KKR) and GoDaddy ($GDDY) will join the big leagues. They will take the places of Robert Half ($RHI), Comeria ($CMA) and Illumina ($ILMN). 

Being included not only brings greater recognition, it also means that ETFs that track the S&P 500, such as $VOO, will need to buy shares of the newly added company. Stocks tend to rally with this announcement, as investors expect higher demand as the adjustment period begins. Rebalancing involves an unusual level of transparency and planning in an unpredictable environment. 

Hedge funds even try to front-run these shifts to take advantage of potential price fluctuations. While it may seem straightforward, there’s no certainty of any trading strategy. In March 2020, S&P Dow Jones Indices and the Nasdaq decided to delay the rebalancing process due to high levels of volatility, causing losses for many hedge funds. 

Indices often add more conditions than market cap. The Nasdaq-100, for example, excludes financial companies. This index’s composition was affected by the outperformance of big tech stocks, and became too concentrated. To try to maintain a level of diversification, a ‘special rebalance’ event in July 2023 reduced weightings in Microsoft ($MSFT), Apple ($AAPL), Nvidia ($NVDA), Amazon ($AMZN) and Tesla ($TSLA). 

Building indices is not always an exact science. The Dow Jones, launched in 1896, is supposed to present a measure of the U.S. economy’s health through the performance of 30 blue chip stocks. Selection into this group involves a committee judging a company’s growth journey, investor interest, reputation and whether its sector represents the broader market. 

There’s no specified timeline for changeovers. Amazon was the latest addition in February; Procter & Gamble ($PG) has been included since 1932. There’s speculation that Nvidia could be next, particularly after its recent 10-for-1 stock split. As the Dow’s components are weighted by share price rather than market cap, Nvidia would now fall into the middle of the group. Its previous price of over US$1,200 per share would’ve had an outsized influence on the index. 

If we consider financial markets are often described as complicated ecosystems, index rebalancing is akin to a change of season. As temperatures change and we head to the halfway point of the year, it’s a reminder for us all to pause, take stock and ensure everything is still on track.