Indexes Change. Should Your Buy-and-Hold Approach?


Many investors imagine that passive investment vehicles based on market-cap indexes are buy-and-hold portfolios, with essentially a “slice of the market” purchased and then locked away. However, this is far from the truth. Indexes are actually in a continual state of change because index providers regularly alter the membership and weights of index members, a process known as index rebalancing or index reconstitution.

For example, this month Russell will announce the reconstitution of all its indexes, and the S&P 500® Index adds and drops companies throughout the year. These constant changes cause passive managers to buy entering names and sell exiting names while trueing other positions to reflect weighting and other membership changes.

The degree of turnover due to index reconstitutions isn’t tiny. The table below shows the 2017 turnover for a handful of popular indexes—the percentage of the portfolio that was bought and sold over the time period.


Sources: Parametric, S&P®, Russell®, MSCI

Focusing on the S&P 500® Index, note that over the past 10 calendar years it has replaced an average of 19 new companies. In fact, of the 500 names in the index in 2007, 185 have since been dropped. That’s over one-third of the companies from 10 years ago that have been “sold” from the index.

 Survival of the S&P 500® constituent list over the past 10 years

Survival of the S&P 500

Sources: Parametric, Factset

How do indexes decide which companies to add and drop?

Changes to the S&P 500® Index are initiated by an index committee, which is tasked with creating a theoretical portfolio representing the large-cap segment of the US equity market. The committee also strives for sector composition resembling that of the total market while limiting representation to 500 names.

The committee typically deletes a company from the index when the stock drops in value so much that it falls below the definition of large cap. This was the fate of a number of airlines and automakers during the global financial crisis of 2008–2009. Any deletions are then balanced with additions to maintain the 500 names.

How do index reconstitutions affect a portfolio?

All the adjustments a passive manager must make in the background when indexes change have real-world consequences. For example, if a company is dropped from an index, causing the manager to sell that name from the portfolio, that sale has potential tax consequences if there’s been a large gain from it. Multiply this by the index turnover shown earlier, and it’s easy to see how tax costs over time could eat up quite a bit of return in the portfolio.

We believe a more thoughtful approach lies in evaluating the tax effect of any change to the passive portfolio. If selling a given security would come at a significant tax cost, it may not be wise to execute that sale. Instead it may be better to accept the inconsistency between the index and the passive portfolio in the short term and look to balance sector or other weighting factors elsewhere. In other words, to follow the index in spirit, if not in letter.

The bottom line

Indexes change, and often for reasons that are difficult to anticipate. Keeping your clients’ passive investments in line with the index is a job in itself—as is the tax management of those investments. Neither should be overlooked, since realizing consistent index-based returns depends on them.

Potential Parametric solution

Custom Core® seeks to combine the consistent performance and diversification of index-based ETFs and mutual funds with the benefits of a customized separately managed account to deliver after-tax returns above a benchmark.

Rey Santodomingo

Rey Santodomingo, CFA, Managing Director of Investment Strategy

Rey is responsible for all aspects of Parametric’s tax-managed equity strategies. As one of the primary strategists for Custom Core®, he works closely with taxable clients and advisors to design, develop, and implement custom portfolio solutions. Prior to joining Parametric in 2008, Rey was a vice president in product management at MSCI Barra. He earned an MA in financial engineering from the University of California, Berkeley, and a BS in chemical engineering from the University of California, Santa Barbara. A CFA charterholder, Rey is a member of the CFA Society of Seattle and a prior board member of the CFA Society of Seattle. He has also served as an adjunct instructor at Seattle University's Albers School of Business and Economics.
