What Happens When the Stocks in an Index Change?

December 15, 2022
Learn why stock indexes change their components and how it can affect the index.

Since its debut in 1896, the Dow Jones Industrial Average® (DJIA®), often shortened to "the Dow," has been one of the most widely watched stock indexes in the world. For many investors, it's the only one that's a household name, meaning your uncle might ask you, "How did the Dow do today?" when what he really wants to know is whether the market went up or down.

Because of the Dow's 126 years of longevity, just as with all indexes—such as the S&P 500® index (SPX), Nasdaq Composite® (COMP), and Russell 2000® (RUT)—the stocks included in the index change over time. That's why most of the original companies in the Dow (for instance, Chicago Gas and Distilling and Cattle Feeding) aren't part of the index anymore. The same changes occur with all indexes, including the S&P 500, Nasdaq®, Russell 2000, and about 5,000 others, big and small.

In fact, those changes continue even now. Here are some examples:

  • Zapped: In June 2018, General Electric (GE)—the last original member dating back to 1896—was removed from the Dow and replaced by pharmacy retailer Walgreens Boots Alliance (WBA).
  • Have a byte: Although Apple (AAPL) first became the largest company in the world in 2011, it wasn't until 2015 that it was invited to join the Dow, replacing AT&T (T), a company that has been in and out of the index several times over the last 100 years.
  • Major reshuffle: On one fateful day in 2013, the Dow gave three companies—Bank of America (BAC), Alcoa (AA), and HP (HPQ)—the big boot and replaced them with Goldman Sachs (GS), Visa (V), and Nike (NKE).

Investors should understand that when an index changes, the move can affect the price of individual stocks being added or dropped as well as funds based on the index itself. Understanding the mechanics of an index shake-up—and how it can affect your portfolio—can help identify trading opportunities by making sure you don't get caught off guard when change comes.

Dissecting a stock index

An index is created by selecting a group of stocks and then applying either a direct (simple) or indirect (complex) calculation to determine the weighting of each stock. An example of a direct calculation would be adding the share prices of all the included stocks and using that total as the index price. An indirect calculation could involve adding all the share prices, dividing by the number of stocks, and then multiplying by their individual average trading turnover, market capitalization ("market cap"), or any other variable.

Most indexes are calculated using an indirect method, including the Dow, which is a price-weighted index. The index value is calculated by Dow Jones' proprietary methodology, which includes adding the share prices of the 30 component stocks and dividing by the "Dow Divisor." The resulting index value is published daily.

The index value for the S&P 500 is calculated in a similar manner—divisor and all—but the 500 component stocks are weighted differently. Instead of price, the S&P 500 weights stocks by market cap. To be eligible for the index, stocks must meet other criteria, such as liquidity, number of shares in the secondary market ("the float"), and the length of time shares have been publicly traded.

Without getting too far into the weeds math-wise, using a divisor simplifies the process of replacing stocks in the index and rebalancing the weightings, as well as factors in the effects of dividends, stock splits, and other corporate actions. In general, whenever there's a change, the divisor is tweaked up or down to keep the index value consistent before and after the change.

Why do indexes need to be rebalanced?

Change is a constant part of life that you either fear or embrace, but you can't avoid it. In the stock market, micro changes happen daily to individual stocks with every new tick. Over the course of a year, companies are listed or delisted, existing firms are acquired or merge with other companies, and small companies can grow into large companies (or vice versa).

On a macro level, it happens when a stock is added to or removed from an index, whether through a periodic "rebalancing" or when a company no longer meets the index's eligibility criteria. Without regular rebalancing, an index can become overweighted toward a small group of stocks or a particular sector.

There are no rules governing the frequency of index rebalancing, but many experts suggest it should be done annually. The Russell 2000 does a complete top-to-bottom rebalance—called a "reconstitution"—every June to more accurately reflect the current equity market.

To understand the need for periodic rebalancing, consider the case of a company like Amazon (AMZN). In August 2022, Amazon had a market cap of about $1.36 trillion and was one of the biggest companies in the world. But at one time—not too long ago, in the grand scheme of things—it was part of the Russell 2000, an index that tracks small-cap stocks. As the company grew, rebalancing removed the stock from that index and added it to the Russell 1000®, which is a large-cap index. Who knows what smaller and relatively unknown names now in the Russell 2000 might one day graduate to a large-cap index? That's part of the fun.

Doing the (stock) splits

Rebalancing also can be prompted by a stock split. For example, in 2020 the Dow flipped six companies in one day after Apple's decision to split its stock 4:1—turning each existing share into four. To accurately reflect the split, each share price was valued at one-quarter of the previous share. That lower price change meant the price-weighted Dow needed to be drastically recalibrated.

To keep things on an even keel, the Dow managers made several changes:

  • Tech firm Salesforce (CRM) replaced energy behemoth ExxonMobil (XOM)
  • Biotech stock Amgen (AMGN) replaced consumer health care stalwart Pfizer (PFE)
  • Tech and aerospace firm Honeywell International (HON) replaced aerospace/defense company Raytheon Technologies (RTX)

The changes were designed to offset the reduction in Apple's share price. They also helped diversify the index by removing overlap between companies of similar scope and by adding new types of businesses that better reflect the broader U.S. economy—the entire purpose of the Dow.

How index rebalancing affects individual stocks?

With the rise of exchange-traded funds (ETFs) and index investing, there's been a greater focus on the addition and subtraction of stocks from indexes, including those that are widely followed, such as the Dow, S&P 500, and Nasdaq. This is because many institutional investors attempt to mirror the performance of these indexes by buying the same stocks. Some funds are even required by their charter or offering prospectus to hold the same stocks.

So, when a stock is added to a widely followed index, millions—and sometimes billions—of purchase dollars flow into that stock, typically driving its price higher. Conversely, when a stock is dropped from an index, it's often sold by institutional players, usually causing it to drop in price. However, these price fluctuations are usually short-lived, and some studies indicate that just being a part of an index has no permanent effect on a stock's value.

When a stock is added to an index, it's often done based on a sustained increase in earnings, appreciation in market value, and positive price momentum. Because of those factors, a stock may exhibit better performance following its addition to an index. But if those factors change, a stock can underperform, even if it's still part of the index.

An interesting corollary is that a stock can be dropped from an index, not because it's been underperforming, but because the index allows only a set number of stocks and room needs to be made for a new one. This can represent a buying opportunity when a stock whose fundamentals remain strong on the initial selling after being dropped from the index.

Rebalancing is a simple fact of life in the world of indexes, so it's good to understand the timing and dynamics.

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Content intended for educational/informational purposes only. Not investment advice, or a recommendation of any security, strategy, or account type.

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