Weighting Whiplash
Unexpected things can happen when arbitrary index methodology rules are applied with dogmatic adherence.
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
DISCLOSURES
The information in this material is intended for the recipient’s background information and use only. It is provided in good faith and without any warranty or representation as to accuracy or completeness. Information and opinions presented in this material have been obtained or derived from sources believed by Dimensional to be reliable, and Dimensional has reasonable grounds to believe that all factual information herein is true as at the date of this material. It does not constitute investment advice, a recommendation, or an offer of any services or products for sale and is not intended to provide a sufficient basis on which to make an investment decision. Before acting on any information in this document, you should consider whether it is appropriate for your particular circumstances and, if appropriate, seek professional advice. It is the responsibility of any persons wishing to make a purchase to inform themselves of and observe all applicable laws and regulations. Unauthorized reproduction or transmission of this material is strictly prohibited. Dimensional accepts no responsibility for loss arising from the use of the information contained herein.
This material is not directed at any person in any jurisdiction where the availability of this material is prohibited or would subject Dimensional or its products or services to any registration, licensing, or other such legal requirements within the jurisdiction.
“Dimensional” refers to the Dimensional separate but affiliated entities generally, rather than to one particular entity. These entities are Dimensional Fund Advisors LP, Dimensional Fund Advisors Ltd., Dimensional Ireland Limited, DFA Australia Limited, Dimensional Fund Advisors Canada ULC, Dimensional Fund Advisors Pte. Ltd., Dimensional Japan Ltd., and Dimensional Hong Kong Limited. Dimensional Hong Kong Limited is licensed by the Securities and Futures Commission to conduct Type 1 (dealing in securities) regulated activities only and does not provide asset management services.
RISKS
Investments involve risks. The investment return and principal value of an investment may fluctuate so that an investor’s shares, when redeemed, may be worth more or less than their original value. Past performance is not a guarantee of future results. There is no guarantee strategies will be successful.
CANADA
These materials have been prepared by Dimensional Fund Advisors Canada ULC. The other Dimensional entities referenced herein are not registered resident investment fund managers or portfolio managers in Canada.
This material is not intended for Quebec residents.
Commissions, trailing commissions, management fees, and expenses all may be associated with mutual fund investments. Please read the prospectus before investing. Unless otherwise noted, any indicated total rates of return reflect the historical annual compounded total returns, including changes in share or unit value and reinvestment of all dividends or other distributions, and do not take into account sales, redemption, distribution, or optional charges or income taxes payable by any security holder that would have reduced returns. Mutual funds are not guaranteed, their values change frequently, and past performance may not be repeated.
Resources
