INDEX REBALANCING IS NOW THE BIGGEST EVENT IN MARKETS / THE ECONOMIST

Index rebalancing is now the biggest event in markets

But profiting from it is another matter

Illustration: Satoshi Kambayashi

What do the Indonesian stockmarket, South Korean government bonds and Robinhood, an online broker, have in common? 

Not much, you might think. 

But over the past year investors in all three have quivered before the same phenomenon: the awesome power of financial indices.

The largest of these now exert a tidal pull on markets. 

As of 2025, around $36trn-worth of capital was in passive investment funds. 

These automatically track decisions by MSCI, FTSE Russell, S&P Global and the like to determine what to buy, and how much. 

Many trillions more are supposedly invested actively, but by “closet index-huggers”—timid managers who fear straying too far from their benchmarks.

Ironically, all this has given rise to a strategy based on discretion and guesswork. 

Hedge funds and other traders try to surf ahead of the wave of portfolio rebalancing generated by indices changing their weights. 

Some corkers are on the horizon, with buzzy and enormous firms such as SpaceX and Anthropic expected to list their shares in the coming months, and to join stockmarket indices soon after. 

Sadly, making money from such events is getting harder.

If markets were perfectly efficient, it would always have been nigh-impossible: as soon as an asset looked likely to enter an index, its price would adjust to anticipate tracker funds’ rebalancing. 

But markets are not perfect and index rebalancing is large enough to move them. 

Goldman Sachs, a bank, reckons $7.8bn could flow out of Indonesian stocks if the country is downgraded to a “frontier market” by MSCI in June. 

The share price of Robinhood surged by 16% in September after it joined the S&P 500 index. 

South Korean bonds’ entry into the FTSE World Government Bond index this year may drag in as much as $60bn-worth of foreign investment.

Why, then, is it getting harder to profit by trading ahead of these events? 

One reason is that index rebalancing rewards periods of sustained momentum. 

Shares that have climbed rapidly in value are admitted to indices, then bought automatically by tracker funds, giving them another boost. 

If you can identify one such winner earlier than your competitors, you can buy it before the bump. 

Provided it keeps winning, so will you.

If its momentum stalls, you will not—both because you own a stock that is faltering and because it might not now enter the index after all. 

In two separate months last year, index-rebalancing strategies run by Millennium Management, a hedge fund, came a cropper in this way and booked losses worth hundreds of millions of dollars, snapping long winning streaks. 

They did so just as momentum reversed (meaning that winners began to lose and vice versa). 

When momentum becomes unreliable, as it has sometimes been recently, so too are index-rebalancing strategies.

More important, as traders have learned to make these sorts of plays, competition has squeezed profits. 

Research by Robin Greenwood and Marco Sammon, both of Harvard Business School, shows that the average stock added to the S&P 500 in the 1990s beat the index by 7.4 percentage points between announcement and inclusion. 

Since 2010 the average such bump has fallen below a single percentage point.

Even the most unlikely investors are getting in on the action. 

Norway’s gargantuan sovereign-wealth fund has $2.3trn in assets, much of it in effect invested passively. 

Yet it made $4bn last year through arbitrage, including around the rebalancing of indices.

Many so-called tracker funds in truth exercise far more discretion than the label suggests. 

This might be necessary to avoid being the “dumb money” on the other side of index-rebalancing trades. 

Research by Peter Molk of the University of Florida and Adriana Robertson of the University of Chicago finds that even the largest S&P 500 funds had allocations that diverged from the index by between 1.7% and 7.5% of their assets in the final quarter of 2022. 

This amounted to over $60bn-worth of stockpicking decisions.

The fate of any successful arbitrageur is a melancholy one. 

Profitable trades shrink the avenues for arbitrage that first attracted them to the market. 

At their very best, they help to make financial markets function more smoothly even as they erode their own advantages. 

There will still be money to be made for such traders in the months and years to come. 

But even as the importance of index rebalancing grows, the golden days of the strategy are probably over.