Index Rebalancing Is STILL a Rain-Maker Trade. [Code Included]

One fund's trash is another trader's treasure.

Index rebalancing is a simple trade. When an index such as the S&P 500 announces changes to its components (e.g., removing Stock A), the prices of the stock tend to reflect that in the ongoing future. This trade is lauded not just for its simplicity, but for its role as a major profit center. But don’t just take my word for it:

Despite this widespread use, or perhaps because of it, there are now concerns that the strategy has been “arbed out”. In the 2022 paper, The Disappearing Index Effect, the authors found that when a stock was added to the S&P 500, it posted an average 7.6% excess return in the 1990s, a 5.2% return in the 2000s and finally a 0.8% return in the 2010’s:

This has caused a few of the major players to depart from the space:

A Once-Reliable Trade Is Becoming So Popular It May Be Falling Apart

But here at The Quant’s Playbook, we feast on the leftover scraps. While the crumbs on the table aren’t enough to fill the stomachs of the largest funds anymore, those thrown-away scraps are our bread and butter. So, this brings us to ask: is this edge really gone, or is it just not as profitable for the big guys as before?

To figure this out, we’ll need to create our own index rebalancing framework from scratch, then glue the pieces together into a working strategy.

Without further ado, let’s get right into it.

How Do These Things Work Anyway?

In order to trade stocks effected by a rebalance, it’ll help to actually know the criteria of which stocks will be added/removed and when it will occur. Thankfully, this criteria is freely published by the index providers (e.g., Standard & Poor’s), so we can start hands-on by predicting which stocks will be added/removed from the S&P 500 in the future.

According to the latest S&P Global Methodology, the big-picture criteria for stocks to be included in the S&P 500 are:

• U.S. domiciled, exchange-listed only (e.g., No ADRs)

• Minimum market capitalization of $14.5 billion

• Earnings of the most recent quarter must be positive, as well as the sum of the previous 4 (net income).

• Float-adjusted liquidity ratio (FALR) greater than or equal to 0.1

  • FALR = Yearly Volume / Market Cap

    • For example, a $50b stock must have a yearly trading volume of at least $5b to be eligible (5/50 = 0.1)

Knowing this rule-set, we can use free tools like Finviz to screen this filter to all stocks and see what comes up:

As expected, there is a large overlap of these stocks that are already included in the index (the top 500). The index rebalances on a quarterly basis or whenever a component is acquired, so our next step is to see which stocks meet the current criteria, but aren’t in the index yet.

More often than not, components follow a “graduation” approach where those added to the index are often already in the S&P Midcap 400 and outgrow that index. Currently, Deckers Outdoors (NYSE: DECK, (Ugg Boots)) meets all of the S&P criteria set above, and has the largest weight in the S&P Midcap 400 at a $16b market capitalization (Mid Cap 400 = $5.2b to $14.5b), so it it is one potential candidate for inclusion at the next rebalance.

However, we don’t even have to trouble ourselves with narrowing down and predicting the next inclusion/deletion, we can eliminate the guesswork by structuring a trade that gets initiated after the announcement is made.

In theory, stocks that are added to the index go higher because of the passive buying of ETFs which track that index. Conversely, stocks removed from the index go lower because of the initial selling, followed by the proceeding lack in coverage. For deleted stocks, it would require significant news after the exclusion to be relevant enough to investors for them to start buying it again.

So, now that we understand the process and the overall theory behind the trade, let’s put it into action.

How Much Are The Crumbs Worth?