Learn What Is Index Fund Rebalancing Strategy in Algo-Trading

Since the beginning of the stock market, new methods of opportunities have been introduced in each decade. There are indices like the Sensex and Nifty, which have become top indices to watch and observe in India. With the hike in online trading, retail investors seem to increase their interest in investing in the financial market. The index fund rebalancing is essential in order to update index funds over the rise or fall of nifty or other indices. Having a basic understanding of the function of an index fund will help investors invest in a smart way.

Let’s start by understanding the meaning of Nifty and Sensex. There are many activities that are related to the index, and rebalancing this index is important for the overall stock market. In the rebalancing process, companies are being added or removed from the following indices, and the whole news can be accessed in the financial news or website. Therefore, in this article, you will learn about the rebalancing of indices and rebalance strategies that can create a perfect balance in the following indices.

How Does Rebalancing an Index Work?

Before answering the above question, it is important to know what index fund rebalancing is. The rebalancing of a portfolio or a market index refers to the rebalancing of the composition of an investment portfolio. This helps keep the portfolio balanced and diversified. So, if you want to dive deep into the concept of rebalancing strategy, you must be aware of different market instruments. However, the rebalancing of indices requires adding or removing shares in order to manage the weight and up and down of financial assets. Rebalancing a portfolio is vital for an optimised financial portfolio over a time period. Changing the asset can help the stock indices to move toward a positive position and avoid disruption in the stock indices.

In India, indices such as Sensex and Nifty are extremely important and useful indices for retail and institutional investors. It is a reliable benchmark to compare the performance of the overall market. The indices also work as indicators to provide a glimpse of a country’s market and economy.

Let’s return to the question of how this rebalancing works. Well, traditionally, these indices are assets allocated with 50% stocks and 50% bonds. But if the stock price rises over a period of time, then the allocation process will shift from 50-50 to 70% stock allocation, and the same goes for the bonds allocation. Depending upon the situation, the portfolio manager can align the percentage of financial instruments in the following portfolio.

Type of Rebalancing

There are several types of rebalancing. These are:

Calendar Rebalancing

Calendar rebalancing refers to analysing and adjusting the financial holding within the portfolio at a predetermined time. Lots of long-term investors rebalance their portfolios once a year. Depending upon goals and market condition, the investor rebalances their portfolio quarterly, monthly, or yearly. There are also weekly rebalances, but this can cost a penny to the investor fees. One major benefit of calendar rebalancing is that it can be more responsive and that it is less time-consuming and costly for the investor. But the drawback of this rebalancing is that there are no changes at the time of market movement, as the date is pre-scheduled for the rebalancing process.

Constant-Mix Rebalancing

In constant-mix rebalancing, the focus is on the percentage of composition of an asset in a portfolio. In a portfolio, every asset class has assigned a specific range. An allocation strategy includes a requirement to hold about 30% in emerging market equities, 30% blue chip companies, and 40% in government bonds. This portfolio also has a corridor of 5% of each asset class.

Smart Beta Rebalancing

Smart beta rebalancing is a periodic rebalancing similar to regular rebalancing. Indices undergo changes to adjust to changes in the stock value as well as the market capitalisation. It uses a rule-based approach to avoid market inefficiencies, which seek index investing on the basis of market capitalisation. A smart beta rebalancing uses additional data and metrics such as the book value, return on capital, Profit-Earnings (PE) ratio, and more. This complex strategy of rebalancing the index is quite a layer of systematic analysis, which is lacking in simple index investing. However, smart beta rebalancing is more active than simply using straightforward allocating and deallocating financial assets in the respective indices.

Advantages and Disadvantages of Rebalancing Index Fund

Advantages

• It keeps the portfolio aligned and adjusted according to the market condition.
• You can keep a predetermined asset allocation set by an investment plan.
• The asset balance is based on the logical and strategic investment decision.
• It is handled by experienced individuals or portfolio managers.

Disadvantages

• There is a transaction cause that can harm the portfolio’s net income.
• Unnecessary rebalancing can harm the investment and can disturb the growth of the portfolio.

Conclusion

Market performance is not the only thing that is used in index rebalancing. Regular stock splits and other aspects usually impact the infrequency of the index and lead to the rebalancing process. Rebalancing must be handled in a logical and calculative manner. Doing rebalancing in the eureka of a movement will lead to chaos and wrong decisions.

Frequently Asked Questions (FAQs)