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It's Russell Index Reconstitution Time

Do you know where your index fund is?

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Stock indexes aren't static. Indeed, as we've written before, they undergo regular changes, known as reconstitutions, during which securities are added and deleted. Market conditions change, index components drift up and down the market-capitalization ladder, new listings come on the market, and some stocks go away through bankruptcy or buyouts. So, if an index never added new equities and deleted others, it would eventually drift away from whatever universe of stocks it was meant to represent.

The subject of index reconstitution is of more than academic interest. After all, hedge funds can take advantage of an index's reconstitution to game the system in their favor--a practice known as front-running, which can erode the returns of both index funds and ETFs. And because not all indexes remake themselves in the same way, or follow universes of stocks with the same liquidity characteristics, reconstitution can have different effects on different benchmarks. The way an index rebalances itself can directly affect the returns of the investors in funds that track that index.

Standard & Poor's, compilers of the venerable S&P 500 Index, makes changes throughout the year. When a particular equity needs to be replaced in any of its indexes, S&P's selection committee approves a stock to replace it, only admitting companies with four straight quarters of positive earnings. Russell, on the other hand, compiles its various indexes once a year and uses a quantitative methodology based on float-adjusted market capitalization (the market cap of all shares available on the public market). Russell doesn't exclude unprofitable companies. Both index compilers, however, give advance notice of additions and deletions, which lets index-fund managers plan the trades they'll need to make to minimize the difference between their funds' returns and those of the index.

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Reginald Laing does not own shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.