Since the beginning of the stock market, there is always a new method of opportunities introduced in each decade in the stock market. 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 to invest 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 index. Having a basic understanding about the function of an index fund will help investors to invest in a smart way.
Starting by understanding the meaning of Nifty and Sensex, There are many activities which 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 get to know about rebalancing of index, and rebalance strategy which can create a perfect balance in the following index.
Table of Content
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 is meant to rebalance the composition of an investment portfolio. The step to undertake the modification is due to keep the portfolio balanced as well as diversified. So if you want to deep dive in the concept of rebalancing strategy, you must be aware of different market instruments. But the rebalancing of index 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 optimized financial portfolio over a time period. Changing in the asset can help the stock indices to move toward a positive position and avoid the disruption in the stock indices.
In other words, to know that indices are basically a hypothetical portfolio which is created by the stock exchange which includes only the top companies listed on the respective exchange. These following companies are listed on different stock exchanges. The companies are added to the indices depending on certain conditions. One such criteria of indicates is the market capitalization and there is another category such as sector of index.
In India, indices such as Sensex and Nifty are extremely important 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 the indicator to provide a glimpse of the market and economy of a country.
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 the period of time then the allocation process will shift from 50-50 to a 70% stock allocation and 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 type of rebalancing, you can go through each of them respectively
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Calendar Rebalancing
A calendar rebalancing refers to analyzing and adjusting the financial holding within the portfolio at a predetermined time. Lots of long term investors rebalance their portfolio once a year. Depending upon goals and market condition the investor rebalance quarterly, monthly or yearly their financial portfolio. 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 these rebalancing is that there are no changes at the time of market movement, as the date is pre scheduled for the rebalancing process.
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Constant- Mix Rebalancing
In the constant-Mix rebalancing where the focus is on the percentage of composition of an asset in a portfolio. In the following portfolio every asset class has assigned a specific range. An allocation strategy includes a requirement to hold about 30% in the emerging market equities, 30% blue chip company and the 40% in the government bonds. This portfolio also has a corridor of 5% of each asset class.
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Smart Beta Rebalancing
In the smart beta rebalancing, a periodic rebalancing similar to the regular rebalancing, indices undergo changes to adjust to changes in the stock value as well as the market capitalization. It uses a rule-based approach to avoid market inefficiencies, which seek index investing on the basis of market capitalization. A smart beta rebalancing uses the additional data and metric such as the book value, return on capital, P/E ratio and more. This complex strategy of rebalancing the index is quite a layer of systematic analysis which is lacking by simple index investing.
Although smart beta rebalancing is more active then simply using straightforward allocating and deallocating financial assets in the respective indices.
Advantage and Disadvantage of Rebalancing Index fund
As the rebalancing is important there are few averages that should be known by an investor.
Advantages
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It keeps the portfolio aligned and adjusted according to the market condition.
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You can keep a predetermined asset allocation set by an investment plan.
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The asset balance is based on the logical and strategic investment decision
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It is handle by experienced individual or portfolio managers
Disadvantages
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There is a transaction cause which can harm the portfolio net income.
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Unnecessary rebalancing can harm the investment and can disturb the growth of the portfolio.
Conclusion
As you have understood the indices and the rebalance purpose. Suppose if the index only includes companies that meet a certain criteria then investing in those will be obsolete. Market performance is not only the thing which is used in index rebalancing. Regularly, stock splits and other aspects usually impact the infrequency of the index and lead to the rebalancing process. Rebalancing must be handle by logical and calculative manner, doing rebalancing in the eureka of a movement will lead to chaos and wrong
