What is 'Reconstitution'

Reconstitution involves the re-evaluation of a market index

BREAKING DOWN 'Reconstitution'

Reconstitution involves sorting, adding and removing stocks to ensure that the index reflects up-to-date market capitalization and style. An index fund, a subset of mutual funds or ETFs, has a portfolio that, by design, tracks the components of an established market index.

The Russell indexes are a well-known an example of a stock exchange that goes through an annual reconstitution. In this case, all publicly traded stocks ranked in order by market capitalization form the basis of the annual reconstitution. New indexes are further shaped by separating out stocks that have become ineligible and adding newly ranking stocks.The Russell indexes are influential enough whereby other index funds track them, so the Russell reconstitutions tend to have direct and immediate impact, changing the constitution of various other index funds, which in turn affects prices and investor holdings. Other indexes tracked by index funds include the Dow Jones Industrials, Standard & Poor's 500 Index (S&P 500), and the NASDAQ 100.

The reconstitution process for the Russell 3000 works as follows between May and June of a given year: Rank Day occurs early in May, which is when a preliminary list of the largest 4,000 publicly traded stocks are ranked and assessed. The end goal is determining which of these will make the reconstituted Russell 3000 Index. Later, in early June, FTSE Russell posts preliminary changes to the list on their website. A week later, FTSE Russell posts an updated version of this membership list. A week after that, the final reconstituted indexes go into effect at the close of market day, and are traded at the open of the next trading day.

Understanding the Effects of Reconstitution for Investors

The process of reconstitution is an efficient way of reflecting changing investor confidence in companies represented on these lists. With their public notifications over a series of weeks, indices give investors and traders a heads up on the companies that will move to and from their respective index. Since the stocks of the companies affected may see a huge uptick in buying or selling, there is potential for the investor to take quick advantage of these changes and potentially make a quick profit.

Yet an investor in index funds must remember that index managers need to buy the additions and sell the exclusions according to this reconstitution and nothing else; they do not make these changes based on the performance of the stock but rather to match the reconstituted index the fund tracks.

The reconstitution effect, then, means that securities added to the index will typically have greater purchase demand, raising prices, and for the index’s deletions, declining prices. So the index generally adds securities at higher prices and deletes securities at lower prices than it would have if no assets had been tracking it because index managers seek liquidity on or near the index reconstitution date.

But afterward, index managers no longer feel these liquidity demands, and so the price effect generally goes into a reversal, with an index’s additions underperforming and deletions outperforming. This can negatively impact performance on all funds tracking these indices.

  1. Russell 3000 Index

    The Russell 3000 Index is a market-capitalization-weighted equity ...
  2. Russell 3000 Value Index

    Russell 3000 Value Index is a market-capitalization weighted ...
  3. Russell Top 200 Index

    The Russell Top 200 Index is a market capitalization weighted ...
  4. Russell 3000 Growth Index

    The Russell 3000 Growth Index is a market capitalization weighted ...
  5. Russell 2000 Index

    The Russell 2000 index measures the performance of approximately ...
  6. Russell Top 50 Index

    The Russell Top 50 Index is a market capitalization weighted ...
Related Articles
  1. Investing

    Key Factors Of The Russell 2000 Index

    The Russell 2000 index represents the small cap universe, with a broad selection of fast growth companies at the bottom end of the capitalization spectrum.
  2. Investing

    IWM: iShares Russell 2000 Index ETF

    Find out more about the iShares Russell 2000 exchange-traded fund, or ETF, the characteristics of this ETF and its suitability for investing.
  3. Investing

    The Top 3 ETFs For Investing in the Russell 200 Index (IWL, IWY)

    Learn about three ETFs that track the Russell Top 200 Index and how these ETFs have a very high correlation with the S&P 500 index.
  4. Investing

    IWD: iShares Russell 1000 Value ETF

    Learn about the iShares Russell 1000 Value exchange-traded fund (ETF), which invests in value stocks that are included in the Russell 1000 Value index.
  5. Investing

    DIA vs. IWL: Comparing ETFs with the Largest U.S. Companies

    Find out how the SPDR Dow Jones Industrial Average ETF compares with the iShares Russell Top 200 as mega-cap exchange-traded funds.
  6. Retirement

    REQTX: Top 4 Russell Funds for Retirement

    Discover four mutual funds administered and managed by Russell Investments that would add diversification benefits to a retirement portfolio.
  7. Insights

    This Bull Market Is Supported by the Index Funds Investment

    The massive growth of index funds has been supporting the bull market and could lead to a steeper correction when it happens.
  8. Investing

    TNA: Direxion Small Cap Bull 3X ETF

    Read about a triple-leveraged exchange-traded fund that aims for 300% of the returns of the Russell 2000 Index: the Direxion Small Cap Bull 3X.
  9. Investing

    The 3 Best ETFs to Short Small-Cap U.S. Equities (SBB, TWM)

    Get analyses of the top three ETFs to short the U.S. small-cap equity market, and learn about their characteristics and historical performances.
  1. What should I use as a benchmark for my small-cap stock portfolio?

    The Russell 2000 and S&P SmallCap 600 are two of the best indexes to use as a benchmark for small-cap performance. Read Answer >>
  2. Is there such a thing as a nano cap or micro cap index?

    While there are indexes that track micro cap stocks, there are few indexes tracking nano caps. Although definitions vary, ... Read Answer >>
Hot Definitions
  1. Diversification

    Diversification is the strategy of investing in a variety of securities in order to lower the risk involved with putting ...
  2. Intrinsic Value

    Intrinsic value is the perceived or calculated value of a company, including tangible and intangible factors, and may differ ...
  3. Current Assets

    Current assets is a balance sheet item that represents the value of all assets that can reasonably expected to be converted ...
  4. Volatility

    Volatility measures how much the price of a security, derivative, or index fluctuates.
  5. Money Market

    The money market is a segment of the financial market in which financial instruments with high liquidity and very short maturities ...
  6. Cost of Debt

    Cost of debt is the effective rate that a company pays on its current debt as part of its capital structure.
Trading Center