In the world of exchange-traded funds, some investors tend to look at index-based ETFs as static alternatives to the more flexible active funds. However, that is not necessarily the case. Index-based funds do move their assets around, particularly when their underlying indexes rebalance at points throughout the year.
“In the world of index-based ETFs, regular reconstitutions and rebalances are the ‘maintenance work’ that ensures the fund actually does what it promises,” noted Dalton Easterwood, CFA, head of index product at VettaFi. “Without a reconstitution, the ETF could hold ‘zombie’ stocks that no longer meet the index’s criteria, causing style drift. Without a rebalance, and if left unchecked, a few massive companies could eventually make up 50% of the fund, destroying the diversification the investor paid for.“
Index Funds: More Fluid Than You Think
For instance, a slew of different VettaFi indexes are rebalancing on Friday, December 19. This rebalancing will not only affect the indexes themselves, but the popular ETFs that utilize the indexes as well.
One such fund is the ALPS Sector Dividend Dogs ETF (SDOG ). SDOG uses the S-Network Sector Dividend Dogs Index as its index of choice.
This index looks to get high dividend exposure across each of the 10 market sectors. To do so, the index picks the five securities in each sector with the highest yield and weighs them equally.
The rebalancing is also affecting thematic ETFs like the ALPS O’Shares Global Internet Giants ETF (OGIG ). This fund uses the O’Shares Global Internet Giants Index.
Its strategy tracks stocks in the internet sector that are displaying not only quality characteristics, but growth traits as well. Eligible companies must generate the lion’s share of their revenue from either the internet or e-commerce sectors.
Much like OGIG, the Procure Space ETF (UFO ) could see a shift from the index rebalancing this month. UFO’s strategy revolves around the use of the S-Network Space Index.
True to its name, this index looks to generate focused exposure to space-related businesses. This includes both satellite operators or companies engaged in the sale of space-related hardware.
Due Diligence Matters
Of course, these three funds are not the only three ETFs that may be affected by the index rebalancing this Friday. As such, advisors and investors alike should do their due diligence and monitor when their index funds are slated to be rebalanced, as this can mark a critical shift in both security weighting and potential long-term performance.
“The 3rd Friday of December, falling on the 19th this year, serves as one of the most common rebalance dates across the investment product landscape,” Easterwood added. “One day each quarter four different types of derivatives expire simultaneously. The trading volume from these contracts expiring creates an ocean of liquidity in the market allowing ETFs to implement these important changes with less impact to the stock prices.”
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VettaFi LLC (“VettaFi”) is the index provider for SDOG, OGIG, and UFO, for which it receives an index licensing fee. However, SDOG, OGIG, and UFO are not issued, sponsored, endorsed, or sold by VettaFi, and VettaFi has no obligation or liability in connection with the issuance, administration, marketing, or trading of SDOG, OGIG, and UFO.
