Rebalancing of an index: what it is and how it works

Rebalancing a portfolio or index, as the term indicates, means rebalancing its composition. The rebalancing of an investment portfolio is therefore a modification implemented in order to keep it balanced and diversified, like it was conceived in the beginning according to its stated methodology.

This can be done in various ways, for example: adding new titles and removing others, or buying or selling shares in order to change the "weights" of the various existing components.

Rebalancing is essential for maintaining a balanced portfolio over time, without changing the desired exposure to risk. In the same way, as far as stock indices are concerned, the procedure aims to keep the composition of the index balanced over time.

How does rebalancing an index work?

Rebalancing, for passive indices such as those in Oval, follows a predefined procedure based on an objective methodology initially set, on a regular basis.

What makes index rebalancing a good practice?

A good investment strategy involves taking the right time to understand and select products in line with your medium to long-term goals. However, the investments that make up your portfolio may produce different returns over time, possibly affecting the balance struck in its initial composition with regards to its risk and return characteristics.

The main reason why an index is rebalanced is to stay true to the initial methodology and criteria with which it was initially conceived, and therefore the same risk level and diversification over time.

Risky assets (e.g. stocks) often grow faster than less risky assets (e.g. bonds). While a greater presence of stocks increases a portfolio's expected return, it also exposes a larger portion of it to a potential stock market correction. For example, if the value of stock X increases by 25% while stock Y gains only 5%, a large amount of the value in the portfolio is tied to stock X. If stock X suffers a sudden decline, the portfolio will suffer greater losses by association. During times of high volatility, these changes can lead investors to abandon investment plans, jeopardizing the ability to achieve their financial goals.

Rebalancing allows you to redirect some of the funds currently allocated in stock X to another investment, whether it's more Y shares or the complete purchase of a new stock. By having funds spread across multiple stocks, a decline in one will be partially offset by the assets of the others, which can provide a greater level of stability to your portfolio.

The rebalancing on Oval

We’ve talked about rebalancing your overall portfolio, but thinking about products on Oval, when does a rebalancing occur or could it occur? The indices are rebalanced by our partner Cirdan Capital once a year, following the periodic rebalancing strategy described above. This means that this rebalancing takes place on a predetermined and regular basis.

In what other circumstances can indices be rebalanced?

Market performance is not the only thing to think about for index rebalancing. Regulatory and corporate events, which are usually infrequent, can also lead to a rebalancing. These can include:

  • The delisting of a company in the index. As it is no longer listed, the company is removed from the composition of the product and its weight is redistributed to the other companies in the basket, proportionally to their price.
  • A merger or acquisition involving one or more companies in the index. In this case, if the company that is part of the basket is acquired, it replaces the purchasing company and then the position is rebalanced.
  • Corporate actions (e.g. stock splits). In this case, if the company splits its stock, it’s weight is rebalanced according to the changes this action brings to its value.

If you notice composition changes of the products in the app, this is precisely the reason. We put our users first, and the rebalancing allows us to ensure that the products are always consistent and updated according to their initial methodology, with the intent to follow a number of companies in a balanced and diversified manner.

Oval Marketplace does not provide investment advice. If you are not sure that the product we offer is suitable for you, contact a financial advisor. Past performances are not indicative of future performances.