The reconstitution effect: a concept that many investors overlook, costing them returns.
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Index investing makes sense in theory: buy an index fund (e.g. S&P500) with potential to grow, sit back, and let it ride for several decades. But, have you thought about how those indices pick their stocks?
There is a 58-page set of granular rules for inclusion in the S&P500 index. If those rules changed even the slightest bit today, they would move markets monumentally.
However, there’s a major flaw with the index fund methodology. In fact, the flaw is so massive, that several hedge funds have made billions capitalizing on it.
This flaw is called the index reconstitution effect. Whenever a change is going to be made to the index (e.g. let’s say a new stock is getting added to the S&P), they notify the public of this change weeks in advance, so the index funds tracking the index (like an S&P500 ETF) can make the change on time.
What does that do to the price of the securities? Well, if everyone knows that stock is getting added to an index as well renowned as the S&P500, the demand for it’s shares will go up, drive the price up, and by the time your ETF adds it in a few weeks, you’ve captured no upside in your passive index fund.
To make matters worse, the inflated price of Meta might even go down as the market adjusts to reflect its intrinsic value, and not just the hype around the stock. So you’ve missed out on all the gains leading up to the addition, and you might see some downside in the stock now too.
A famous example of this is Tesla, which had its shares run up nearly 190% in the preceding six months before it was added to the S&P500. Hedge funds profited from this addition and by the time it was added to the S&P500, it was already severely overvalued.