Index construction rules sometimes remind me of that old tea towel explaining the rules of cricket for Americans:
“You have two sides, one out in the field and one in. Each player that’s in the side that’s in goes out, and when they’re out they come back in, and the next player goes in until they’re out. It’s quite simple really.”
Index methodology often seems similarly arbitrary and convoluted.
On 21 June, the S&P Technology Select Sector Index executed its annual rebalance. The event was notable for some significant stock weight changes motivated by diversification constraints.
To maintain regulated investment company tax treatment, the combined weight of security positions with at least 4.8% weight in the index cannot exceed 50% in total.
One solution to avoid breaching the 50% limit is to trim the weights pro rata from all the stocks over 4.8% until the combined total falls below 50%.
S&P’s index methodology dictates a different approach. The excess over 50% is trimmed entirely from the smallest of the group.
The combination of Microsoft, Apple, and Nvidia had already triggered this clause last year.
The difference this year is which stock is the smallest of the group.
Last year, it was Nvidia, meaning it was held at substantially lower weight than Microsoft or Apple to satisfy the combined weight limit.
This year, Apple was the smallest of this trio.
“Smallest” is a relative term, though. All three had market values above $3.29T and, as of 18 June, were within $50,000 of each other. But rules are rules – double-digit weight was transferred from Apple to Nvidia on the rebalance date.
Changes in portfolio composition this dramatic relative to underlying market movements can happen when arbitrary rules are applied with dogmatic adherence.
That’s one of the drawbacks of index fund processes and one that highlights the potential benefit from flexibility in investment decisions.
Howzat again?
EXHIBIT 1
Weight of top 3 constituents in the S&P Technology Select Sector Index before and after June 2024 rebalance
This article originally appeared in Short N Sweet, a newsletter for Dimensional clients.
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