Terms Beginning With 'r'

Rebalancing

Rebalancing is the process of restoring the original weight allocated to the constituents of an index at the time of construction. Many of the market indices are market capitalisation weighted index, and due to the change in the market cap over business activities, the constitutes of an index start experiencing a shift in their original weight in an index. The restoration of the constituents of an index to represent its original allocation is typically known as rebalancing.

What is a Market Index? A market index could be defined as a representation of a security market, market segment, or asset class of freely tradable market instruments. A market index is primarily made up of constituent marketable securities and is re-calculated on a daily basis. There are basically two forms or variations of the same market index, i.e., one version based upon the price return known as a price return index, and one version based upon total return know as a total return index. Why Do We Need A market Index? Ideally, a large number of market participants including investors and institutional funds gather and analyse vast amounts of information about security markets; however, doing so could be a very troublesome and tiring task as the work is both time consuming and data-intensive. Thus, a large number of market participants prefer to use a single measure that could represent and consolidate a plethora of information while reflecting the performance of an entire security market of interest. This is where market indexes play a major role as they are often a simple measure to reflect the performance of any underlying market of interest. For example, S&P500, NASDAQ, are believed to reflect the true performance and picture of the U.S. stock market in particular and U.S. economy in general. Likewise, many indexes such as S&P/ASX 200 is believed to reflect the performance of the Australian stock market and so on. Index Construction Constructing a market index is almost similar to constructing a portfolio of securities as the construction of an index requires: Target Market and Security Selection The first and the primary decision in constructing an index is to identify the target market and select financial instruments which reflect the true nature of the underlying market. The target market, which determines the investment universe and securities available for inclusion, could be based on any asset class, i.e., equities, fixed income, commodities, real estates or on any geographic region. Once the target market is identified, the next step is to select securities which represent the true nature of the target market and decide on the number of securities to be included in the index. Ideally, a market index could be of all securities in the target market or a representative sample of the target market. For example, some indexes such as FTSE 100, S&P 500, S&P/ASX 200, fix the number of stocks to be included in the index while indexes like Tokyo Stock Price Index (or TOPIX) select and represents all of the largest stocks, known as the First Selection. For such indexes, the included securities must meet some basic parameters like pre-decided market capitalisation, the number of shares outstanding, to remain in the index. Weight Allocation The weight allocation varies considerably among indexes depending upon the method of weight allocation, and it basically decides on how much weight each security in an index carry. The method of weight allocation is one of the most important parts that investors need to understand thoroughly as it has a substantial impact on the value of an index. Some of the most widely-used weight allocation methods are as below: Price Weighting This method was originally used by Charles Dow to construct the Dow Jones Industrial Average (or DJIA) and is one of the simplest methods. The price weight method determines the weight of each individual security of an index by dividing the price of the security by the sum of prices of all securities. In simple terms, each security gets the weight of its price in proportional to the total price of the index. The primary advantage of this method is its simplicity; however, the method leads to arbitrary weights for each security as the method is highly sensitive to some market actions such as stock split. Equal Weighting As the name suggests, this method assigns equal weight to all securities in an index. Just like equal weighting, the major advantage of this method is its simplicity; however, this method tends to underrepresent the value of large securities and overrepresent the value of smaller securities. Market-Capitalisation Weighting Market-Capitalisation method weight each constituent by dividing its market capitalisation with the total market capitalisation of the index, i.e., the sum of the market capitalisation of each constituent. The market capitalisation could be determined by multiplying the number of outstanding shares of the security with its market price per share. Rebalancing and Reconstitution Rebalancing of a market index could be defined as the adjustment to the weights of the constituent securities. Depending upon the method of weighting an index, the weight of each individual security tends to change due to market actions or price appreciation and deprecation, in similar fashion to a stock portfolio requires scheduled rebalancing. A majority of market indexes are rebalanced on a daily basis as price tends to often change regularly. On the other hand, reconstitution could be ideally defined as the process to change the constituent of a market index. As suggested above, many market indexes such as TOPIX require each constituent security to meet some parameters for the inclusion; however, due to market dynamics, various securities tend to get added or removed from an index time to time. Uses of Market Index Originally, market indexes were created to provide a sense to investors on how a security market performed on a given day. However, with the development of the modern finance theory and growing numbers of indexes in the market, uses of market indexes have been expanded significantly. Some of the major uses of market indexes are as below: To Gauge the market sentiment A market index is usually a collection of the opinion of market participants; thus, they reflect the attitude and behaviour of the market participants, making them one of most widely used tool to gauge the market sentiment. To measure and model the risk and return profile of a market Market indexes could serve as a proxy for systematic risk in many popular models such as the Capital Asset Pricing Model (or CAPM). The market portfolio, which represents the systematic risk of the market often uses a market index, as a proxy of the market portfolio as including the whole population or all stocks in the model could lead to wrong output, and it could be very costly and cost consuming. Serves as a Performance Benchmark Market indexes often serve as a performance benchmark for individual investors and especially large investors such as mutual funds, ETFs, pension funds, and large banks.

What is the Russell 2000 index? The Russel 2000 index is an index measuring the performance of approximately 2,000 small cap American companies. The companies forming the index are weighted based on their market capitalisation. Consequently, the weights attached to the various component firms change depending on the market capitalisation held by them. This index is operated by FTSE Russell of the London Stock Exchange Group. It was founded by Frank Russell company in 1984. The index is mostly concerned with small cap companies and is also sometimes referred to as “Russell 2K”. It is a part of a broader index called Russell 3000, which also includes the Russell 1000, an index made up of the top 1000 American stocks. Additionally, Russell 3000 makes up for about 98% of the entire investable stock market in the Unites States. Russell 2000 makes up for almost 2/3rds of all American stocks in the market. How does the index work? The average weighted market capitalisation of a company included in the Russell 2000 index was USD 3.76 billion as of February 28, 2021. This index alone accounts for less than 10% of the capitalisation of the US stock market. Russell 2000 excludes stocks that are trading below USD 1 along with pink sheet and bulletin board stocks. Close-end mutual funds, limited partnerships, royalty trusts, foreign stocks and American Depository Receipts are also not part of the index. The index is reconstituted every May as stocks can quickly change categories from small cap to medium cap. Whereas, initial public offerings, if found eligible, are added quarterly. There are various permutations of the Russell 2000 index available in the market. These permutations are formed by taking factors other than market capitalisation as the distinguishing factor. For instance, the Russell 2000 Value index is used to measure the performance of Russell 2000 companies having a lower price-to-book ratio as well as lower forecasted growth values. Similarly, Russell 2000 Growth index measures the performance of those companies in the index which have a higher price-to-book ratio as well as higher forecasted growth value. Which companies form the Russel 2000? As of February 28, 2021, the top 10 index constituents include: Plug Power Inc (Industry: Energy) Penn National Gaming Inc. (Industry: Consumer Discretionary) Caesars Entertainment In (Industry: Consumer Discretionary) Novavax Inc (Industry: Health Care) Darling Ingredients Inc (Consumer Staples) Lithia Motors Inc (Industry: Consumer Discretionary) Sunrun Inc (Industry: Utilities) Deckers Outdoor Corp (Industry: Consumer Discretionary) Ultragenyx Pharma (Industry: Health Care) Builders Firstsource Inc (Industry: Industrials) Healthcare sector forms a large part of the index, followed closely by consumer discretionary and industrials sectors. Consumer staples and telecommunications sectors form the lowest share of the index. The largest market capitalisation held within the index was USD 23.46 billion as of February 28,2021. While the same figure for Russell 3000 was significantly higher at USD 2073.854 billion. The index is rebalanced every year on the last trading day of June. This rebalancing can alter the market by a great degree. The funds dependent on the index as well as some small-cap funds that mirror the movement of the index load up on the new entrants to the index while drop the stocks that leave the index. Why is the Russell 2000 important? The Russell 2000 is a popular and widely accepted benchmark used to gauge the strength of the US stock market. The index may not be as popular as its counterparts like the Dow Jones Industrial Average Index, however it is still a good tracker of the smaller companies in the US stock markets. The index is very much inclusive and is much broader than various other indexes in the market. Investors also compare mutual funds’ performance to Russell 2000 as it a broad index and gives a fairer depiction of the entire market. Most indices fail to cover a large proportion of the market, however, Russell 2000 it covers many stocks in a single index. This makes the index less biased and less stock specific. What are the limitations of the Russell 2000 index? Despite its coverage of the smaller cap stocks, Russell 2000 does not include micro-cap stocks in its calculation. There are hundreds of such companies deemed too small to be included in the index. These micro-cap companies include some of the fastest growing stocks which are not factored into the index. Additionally, only a few sectors have come to dominate the index. The index sees heavy contribution from the financial and healthcare sectors. Thus, this aspect may weigh on stocks belonging to other sectors like communications, telecommunication, etc. How can one invest in the index? To invest in the index, one need not buy all 2000 stocks that the Russell 2000 is comprised of. Investors can directly trade in the index through a mutual fund or exchange-traded fund that shadows the index. Examples of the same include iShares Russell 2000 ETF, Rydex Russell 2000 Fund, Rydex Inverse Russell 2000 Strategy Fund, USAA Small Cap Stock Fund, etc. How is the Russell 2000 different from the Dow Jones Industrial Average Index and the S&P 500 Index? Both these indexes are different from the Russell 2000 based on their composition and usage. Here are some broad differences: Dow Jones Industrial Average Index: The Dow is an exclusive index made up of the top 30 blue chip stocks. This makes the index quite selective and less depictive of the entire market’s movements. In this the company with the highest dollar stock has the largest impact on the index. S&P 500: This index includes the largest 500 companies that are publicly traded. These stocks fall midway between blue chip stocks and the stocks standing in the medium to low cap category. The index covers a sizeable part of the market and includes the most well performing stocks as well.

What is retirement planning? Retirement planning is a process of setting up retirement income goals. A retirement plan is an essential requirement for people seeking independent retirement years. The scope of retirement planning is not only limited to planning goals but also achieving goals.  It involves analysing financial objectives, existing financial situation, and estimating future cash flows to incorporate a comprehensive retirement plan. Retirement planning reduces the risk of outliving savings.  When savings are exhausted, retirees are not able to maintain a similar lifestyle. Retirement planning also enables planning a course of action in the event of unforeseen events like death, disability etc.  It essentially refers to the formulation and implementation of strategies pertaining to investments, savings, and allocation of money. A comprehensive analysis of the person is undertaken that not only includes assets and savings but liabilities, future expenses and life expectancy.  What are the steps in retirement planning? Identifying financial and retirement goals The first step is to enumerate financial and retirement goals. In this step, the retirement planner charts out the ambitions of the person. This step entails the kind of lifestyle a person envisages to lead in retirement.  Retirement planners try to list out all possible retirement goals, including retirement home, holiday planning, marriage planning, retirement time, family planning etc. The motive of this step is to form a base for retirement needs.  Based on the goals extracted in the first step, the planners formulate an appropriate strategy for the person. A successful retirement plan is formed based on goals listed in the first step.  Analysing the current financial situation Financial health is as important as the physical health of a person. Retirement planners seek to test the financial health of the person. They analyse the cash inflows and outflows of the person to estimate the buffer funds. This step also includes analysing the assets held with the person as well as liabilities. Overall commitments are analysed to assess the existing financial situation of the person. Retirement planners also consider insurance policies taken by the person.  They also analyse the savings, or any investments undertaken by the person. A detailed analysis is carried to unveil the risks and opportunities with the existing financial situation of the person.  Risk assessment  Risk assessment is necessary to plan for the unforeseen events. In this step, the planner also evaluates the risk-taking capacity of the individual. In retirement planning, the age factor plays a crucial role in assessing risk-taking ability.  A person seeking retirement planning in the 40s may not have similar risk-taking capacity compared to a person in 20s. The risk factor usually dictates the asset allocation and investment allocation strategy for the individual.  Further, the liabilities of the person are also evaluated extensively to provide potential cover for any expected risks. Retirement planners usually recommend having an emergency fund to cover any risk arising out of unforeseen events.  Asset allocation Asset allocation holds a significant position in the process of retirement planning. It essentially refers to allocating funds to several asset classes to generate an adequate corpus for the retirement life. Money is simply an asset that could be applied to create wealth.  An individual is offered with a range of asset classes in the investment world, spanning from shares, to ETFs to bonds. The asset classes also include real estate, precious metals, fixed deposits, annuities etc.  Asset allocation framework is crucial to achieving prudence and flexibility. It allows generating risk-adjusted returns based on the risk-taking capacity of the individual. A sensible asset allocation framework is the key to achieve desired retirement goals.    Periodic monitoring and rebalancing  A retirement plan may get disrupted by the changes in the underlying conditions of an economy. Likewise, the plan is also equally sensitive to be disrupted by the potential changes in the financial health of the individual.  In the event of a disruption to a plan or financial situation, rebalancing comes to rescue. Individuals also monitor their retirement plan consistently. It is essential to maintain alignment with the goals, and any deviation from the plan should be altered effectively.  Why is retirement planning important? In the simplest form, it is essentially the process of ensuring that when a regular income source is about to get constrained, one has sufficient wealth and income sources to support a desirable lifestyle.  Each person has ambitions, and retirement is perhaps the best time to fulfil those ambitions since working age limits the ability to spend time on ambitions. However, in the absence of a retirement plan, one may have accumulated sufficient funds to live the lifestyle.   Inflation eats out a lot of earning powers as purchasing power at the same amount of money depletes as inflation rises. Over a long term period, the power of compounding can effectively beat the inflation factor in wealth creation.  Retirement plan allows an individual to be self-sufficient in the later years of life when most of the loved ones are far away. It enables elderly people to be confident and self-dependent during their old age. 

We use cookies to ensure that we give you the best experience on our website. If you continue to use this site we will assume that you are happy with it. OK