Index rebalancing and the technology bubble

Abstract

To maintain coverage of their target universe, stock market indices must periodically be rebalanced. This can give rise to turnover that is large, even by the standards of actively managed portfolios. High turnover is not only costly; it can also have a marked impact on reported returns. We demonstrate the problems posed by index rebalancing through a case study of how the year-2000 technology bubble interacted with index rebalancing rules to enhance the performance of a popular index. We draw on this case to discuss the design of performance benchmarks.