What is the Reconstitution Effect and How Does it Impact my Portfolio?

Exchange Traded Funds or ETFs, came into existence in the early 1990’s. They have grown tremendously in popularity by institutional and retail investors alike. As a refresher, ETFs are marketable securities that typically track an index, a commodity, bonds or a basket of assets. One of the major differences between mutual funds and ETFs is that the latter trades like a stock, meaning you can use limit orders, use margins, short positions, and trade throughout the trading session. In addition, like stocks, one of the most likable characteristics of an ETF is that it’s usually very inexpensive. ETFs offer a diverse range of options for investors seeking investments with low fees. From the days of Benjamin Graham to the present, value investors have always touted investments that are broad-based and low cost; ETFs fit the bill.  However, the benefits of ETFs do not come without trade-offs. In order to replicate the index, an ETF fund manager must sacrifice trading flexibility.

Tracking error is the deviation between the price behaviour of an asset and that of a benchmark. The Reconstitution Effect happens when an index (e.g. S&P 500, Russell Index, MSCI, etc.) readjusts its holdings. The index must do this to maintain its perceived integrity as a fair representation of its underlying holdings. Companies grow or shrink in size which causes them to no longer fit in the definition of the market segment that the index is attempting to replicate, such as value, small, large, medium, etc. Therefore, periodically, these indices will “reconstitute” themselves. In other words, some companies will be added to the index and others will be removed. At the time of reconstitution, there are very high liquidity demands, and ETF managers will often experience a sharp increase in trading costs that don’t appear in the expense ratios, but are reflected in net returns. This means that an investor will suffer lower returns in pursuit of low expense ratios. Therefore, investors really need to consider total costs, both in terms of trading costs and expense ratios when evaluating the appropriateness of an asset being added to their portfolio.

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