This week’s Recommended Reading is from Yahoo! Finance and discusses how the simple reorganization of the Russell Indexes may cause the price of Apple’s stock to decline over the next week.
Shares of world’s largest company by market cap, already down more than 8% this year, may fall further as index fund managers are forced to sell roughly $1.3 billion of the stock at Friday’s market close in order to reflect upcoming changes in one of the most widely tracked stock benchmarks. The driver of this activity is the reconstitution, or rebalancing, of the Russell Indexes which are used by many managers as a benchmark for performance. Since index fund managers have one goal, to closely track the index, they will be forced ‘sellers’ when Russell lowers the weighting of Apple in their indexes. This type of rebalancing of the Russell Indexes occurs on an annual basis and the weighting of Apple stock will fall this time due to continued share buybacks by the company and recent poor market performance relative to its peers.
For related bonus reading, we recommend this short research paper, Index Reconstitution: The Price of Tracking, by Dimensional Fund Advisors (DFA). This paper shows the negative impact that index reconstitution can have on index fund performance. As discussed above, when the Index changes it’s weightings, index fund managers are either forced sellers or forced buyers of specific stocks. This creates a large need for liquidity and subsequently can move the market price of those stocks in unfavorable directions.
Not every index fund is as materially impacted by the consequences of index reconstitution. Some index providers have been proactive in this matter and have found ways to mitigate many of the market impacts of adjusting their constituents. Other fund companies like DFA have incorporated this knowledge into their trading strategies to help reduce their need to be forced sellers or forced buyers. This is just one of the many benefits we believe our clients receive by investing in DFA mutual funds