1.1. Rebalancing
Rebalancing is the process of changing the weights of the constituent securities in the index to better reflect the performance of the target markets.
The weights assigned to the constituents at the inception tend to drift from their target weights as the prices of the constituent securities change. This requires the process of rebalancing the weights. For the different kinds of weightings the rebalancing can be done as follows:
a. Equal weights. When the prices of the constituents change, the weights of the securities change; this means that they no longer remain equal-weighted. In such cases, we need to reduce the weights of the securities that have outperformed and increase the weights of the securities that have underperformed, until they become equally weighted again.
b. Price Weighted. The price-weighted indices do not require any rebalancing, since the weights of each of the constituents are determined by the price, i.e. the target weights drift as the prices change. These indices get rebalances automatically.
c. Market-Cap Weighted. These indices need to be rebalanced only to reflect the changes that affect the market cap of the securities or when there is the reconstitution of the capital structure of the constituents such as mergers & acquisitions, liquidations, etc.
1.2. Reconstitution
a. Reconstitution is the process of changing the securities in the index so that the index remains reflective of the target markets.
b. The index should be so reconstituted, that it reflects the changes in the target market resulting from bankruptcy, liquidations, M&A, delisting, etc.
c. The reconstitution reflects the change in the judgment of the selection committee.
d. Reconstitution results in a change in all the weightings; be it price weighting or market-cap weighting.