Why Rebalancing Can Drag an ETFs Performance

Yeah, the topic I wanted to bring up with IWM specifically is the reconstitution or rebalancing strategy that it uses. It creates a potential drag for investor returns based on how it works. It essentially rebalances once a year in June, although I think that's switching to twice annually starting next year.

But it essentially announces the companies that are going to get added and deleted about a month ahead of time. So if you're an arbitrageur or a trader, you start seeing some of that front running. These companies are getting added, they tend to outperform in the leadup and then they fall back once they're added. And then the opposite happens with the deletions as well.

If you look historically, there are studies out there that say that creates like a 20 to 50 basis point performance drag on the index just because of some of that coming and going that happens around the rebalance. So, it does tend to have a material effect, if not necessarily a major effect, but VXF and all the funds that are tied to the S&P indexes, they tend to use more of a rolling addition and deletion strategy.

So, there's no single reconstitution day. It's sort of adding and deleting little by little as the year goes on. So you don't necessarily have some of that front running or some of that big change in trading or liquidity that happens just around a single day.

So this is more of a structural issue than anything. But I'll call the winner in this category VXF just because you don't have that big buy and dump coming around one day for the index. You have it sort of spread out little by little throughout the year, and I think that's better for investor efficiencies.