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Weighting Whiplash

Unexpected things can happen when arbitrary index methodology rules are applied with dogmatic adherence.

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July 16, 2024
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Index construction rules sometimes remind me of the SNL skit “Washington’s Dream,” where Nate Bargatze explains the rationale for switching to the customary unit system for distance: “How many feet to a mile? Five thousand two hundred and eighty, of course. It’s a simple number that everyone will remember.” Index methodology often seems similarly arbitrary and convoluted.

On June 21, the S&P Technology Select Sector Index executed its annual rebalance. The event was notable for some significant stock weight changes motivated by diversification constraints. To maintain regulated investment company tax treatment, the combined weight of security positions with at least 4.8% weight in the index cannot exceed 50% in total.

One solution to avoid breaching the 50% limit is to trim the weights pro rata from all the stocks over 4.8% until the combined total falls below 50%. S&P’s index methodology dictates a different approach. The excess over 50% is trimmed entirely from the smallest of the group.

The combination of Microsoft, Apple, and Nvidia had already triggered this clause last year. The difference this year is which stock is the smallest of the group. Last year, it was Nvidia, meaning it was held at substantially lower weight than Microsoft or Apple to satisfy the combined weight limit. This year, Apple was the smallest of this trio. “Smallest” is a relative term, though. All three had market values above $3.29 trillion and, as of June 18, were within $50,000 of each other. But rules are rules—double-digit weight was transferred from Apple to Nvidia on the rebalance date.

Changes in portfolio composition this dramatic relative to underlying market movements can happen when arbitrary rules are applied with dogmatic adherence. That’s one of the drawbacks of index fund processes and one that highlights the potential benefit from flexibility in investment decisions.

EXHIBIT 1

Weight of Top 3 Constituents in the S&P Technology Select Sector Index before and after June 2024 Rebalance

Data from Cboe Global Markets.Holdings are subject to change. Indices are not available for direct investment. This information is intended for educational purposes and should not be considered a recommendation to buy or sell a particular security. Named securities may be held in accounts managed by Dimensional.

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