What do index funds do when firm's market cap drops?

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bogled_mind
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What do index funds do when firm's market cap drops?

Post by bogled_mind » Wed Oct 17, 2018 11:31 pm

Hi,

There's a line in "The Four Pillars of Investing" (p97) that says:
Today, almost all index funds are "cap weighted." This means that if the value of a stock doubles or falls by half, its proportional contribution in the index does as well, so it is not necessary to buy or sell any to keep things in balance. Thus, as long as the stocks remain in the index, it is not necessary to buy or sell stocks becuase of changes in market value.
Can somebody please explain that a bit further? Let's say Company A makes up half the market (by market cap), and therefore half your "cap weighted" index fund. If Company A falls in value, wouldn't it then be over-represented in your fund? And wouldn't you be forced to either sell some Company A shares to rebalance, or buy more of every other company?

I dread writing this because it will surely come across as a dumb question, so be gentle!

Thanks.

greenhill
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Re: What do index funds do when firm's market cap drops?

Post by greenhill » Wed Oct 17, 2018 11:47 pm

Suppose there are only 2 companies in the stock market, A and B, both making up 50% of the market.
Investing $100 in total stock market fund is the same as investing $50 in company A and $50 in company B.
Now the value of company A drops by 50%. So the $50 invested in company A becomes $25.
Without any rebalance, the total stock market fund would worth $75 now. Company A would make up only 33.3% of the fund now.

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Re: What do index funds do when firm's market cap drops?

Post by bogled_mind » Thu Oct 18, 2018 12:30 am

OK, got it. Thanks!

abc132
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Re: What do index funds do when firm's market cap drops?

Post by abc132 » Thu Oct 18, 2018 1:15 am

If a company pays dividends, and those dividends must be reinvested in weighted portfolio, would the top performers receive a benefit from the dividend payers?

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Earl Lemongrab
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Re: What do index funds do when firm's market cap drops?

Post by Earl Lemongrab » Thu Oct 18, 2018 3:47 pm

abc132 wrote:
Thu Oct 18, 2018 1:15 am
If a company pays dividends, and those dividends must be reinvested in weighted portfolio, would the top performers receive a benefit from the dividend payers?
Dividends are not reinvested in typical mutual funds or ETFs. They are distributed to the shareholders.
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bberris
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Re: What do index funds do when firm's market cap drops?

Post by bberris » Thu Oct 18, 2018 4:21 pm

An index fund does not have to rebalance because one component is revalued against another by the market. The components are cap-weighted, so changes in value are changes in total capitalization. The fund would only need to trade if the index itself is changed.

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Re: What do index funds do when firm's market cap drops?

Post by nisiprius » Thu Oct 18, 2018 4:39 pm

They do nothing. The firm's market cap drops because the price of their stock has dropped. The value of the shares the index fund owns drop, thereby reducing the percentage of the fund's value that is now invested in that stock. It happens automatically as a result of the change in the price of the shares itself. The fund simply keeps holding the same number of shares; it does not need to buy or sell.

This is very important to understand, and it is part of the rationale behind cap-weighting. It is the only weighting that does not require the fund to buy or sell stock in response to stock price movements. So in additional to saving money on management fees, it also saves money on transaction fees.

In contrast, any other weighting requires constant buying and selling of stock.

The reason for this is that index funds are replicas of the market portfolio--the actual shares, all of them, of every stock in the market--and the market itself is cap-weighted.

If you understand this, then you understand why some stories in the press were grossly wrong in 2016. S&P Dow Jones and MSCI had formerly classified REITS as part of the Financials sector. In 2016 they decided to elevate REITs as a separate sector of its own. Thus, the sector composition of the S&P 500 changed. It was incorrectly reported by some reporters that this was going to require S&P 500 index funds to do something. They did not. The S&P 500 stocks continued to be the S&P 500 stocks. WIth no change in the composition of the funds, the new sector definitions automatically applied to both the S&P 500 index itself and to index funds. The stocks that were now classified in the REIT sector resulted in the S&P 500 funds now automatically having an allocation to the REIT sector without needing to buy or sell a single share.
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JoMoney
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Re: What do index funds do when firm's market cap drops?

Post by JoMoney » Thu Oct 18, 2018 4:48 pm

Earl Lemongrab wrote:
Thu Oct 18, 2018 3:47 pm
abc132 wrote:
Thu Oct 18, 2018 1:15 am
If a company pays dividends, and those dividends must be reinvested in weighted portfolio, would the top performers receive a benefit from the dividend payers?
Dividends are not reinvested in typical mutual funds or ETFs. They are distributed to the shareholders.
To add to that, dividends that investors choose to re-invest (or even their new investment contributions) get distributed across the entire market.
If a company is 2% of the market, it get's 2% of the new investment/re-investment, no more, no less.
"To achieve satisfactory investment results is easier than most people realize; to achieve superior results is harder than it looks." - Benjamin Graham

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Re: What do index funds do when firm's market cap drops?

Post by triceratop » Thu Oct 18, 2018 5:05 pm

Earl Lemongrab wrote:
Thu Oct 18, 2018 3:47 pm
abc132 wrote:
Thu Oct 18, 2018 1:15 am
If a company pays dividends, and those dividends must be reinvested in weighted portfolio, would the top performers receive a benefit from the dividend payers?
Dividends are not reinvested in typical mutual funds or ETFs. They are distributed to the shareholders.
This is not exactly true. Dividends are reinvested in typical mutual funds or ETFs. However, an equal amount is also distributed regularly as dividends to mutual fund shareholders on a periodic schedule. So, you might reasonably ask: "well, isn't that not actually reinvesting the dividends, if they are being distributed?" And, no, in the interim (up to a quarter, half-year, or full-year depending on distribution schedule) the dividends are typically reinvested so that the overall return of the fund tracks the compound total return of the index. If the funds didn't reinvest dividends they would lag their benchmark.

Incidentally, there are some ETFs which truly do not reinvest dividends at all, which is why I think the nuanced description above is important. Those are the State Street UITs (which, due to the UIT structure rather than as a regulated investment company are not allowed to reinvest dividends, or even have securities lending operations). An exampls is the State Street S&P500 UIT, the SPY -- which lags the index (S&P500 TR) by more than its expense ratio, as you would expect if it cannot reinvest dividends.
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software
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Re: What do index funds do when firm's market cap drops?

Post by software » Thu Oct 18, 2018 5:25 pm

triceratop wrote:
Thu Oct 18, 2018 5:05 pm
Earl Lemongrab wrote:
Thu Oct 18, 2018 3:47 pm
abc132 wrote:
Thu Oct 18, 2018 1:15 am
If a company pays dividends, and those dividends must be reinvested in weighted portfolio, would the top performers receive a benefit from the dividend payers?
Dividends are not reinvested in typical mutual funds or ETFs. They are distributed to the shareholders.
This is not exactly true. Dividends are reinvested in typical mutual funds or ETFs. However, an equal amount is also distributed regularly as dividends to mutual fund shareholders on a periodic schedule. So, you might reasonably ask: "well, isn't that not actually reinvesting the dividends, if they are being distributed?" And, no, in the interim (up to a quarter, half-year, or full-year depending on distribution schedule) the dividends are typically reinvested so that the overall return of the fund tracks the compound total return of the index. If the funds didn't reinvest dividends they would lag their benchmark.

Incidentally, there are some ETFs which truly do not reinvest dividends at all, which is why I think the nuanced description above is important. Those are the State Street UITs (which, due to the UIT structure rather than as a regulated investment company are not allowed to reinvest dividends, or even have securities lending operations). An exampls is the State Street S&P500 UIT, the SPY -- which lags the index (S&P500 TR) by more than its expense ratio, as you would expect if it cannot reinvest dividends.
Thanks for the description, this makes sense since each individual company is distributing on its own schedule. Something has to be done with that money in the interim, until the fund distributes those dividends to shareholders.

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JoMoney
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Re: What do index funds do when firm's market cap drops?

Post by JoMoney » Thu Oct 18, 2018 5:33 pm

Regarding the S&P 500 index Total Return, an interesting factoid is that there are a couple different S&P 500 Total Return indexes that represent different periods where the 'Total Return' index followed a different scheme reinvesting dividends
http://www.cftech.com/index.php/the-bra ... alculation
... There are four different total-return indices for the Standard & Poor's 500 Index: 1936, 1970, 1988, and year-to-date. Each one uses a different base period. The 1936 and 1970 total return indices were developed for historical use. Dividends are reinvested quarterly from 1936 through 1988 in the 1936 total-return index, and dividends are reinvested monthly from 1970 through 1988 in the 1970 total-return index. The 1988 total-return index is calculated based on daily reinvestment of dividends and uses January 1, 1988, as the base period. The year-to-date total-return index is also calculated assuming daily reinvestment of dividends; however, the base period is the last day of the prior year...
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triceratop
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Re: What do index funds do when firm's market cap drops?

Post by triceratop » Thu Oct 18, 2018 5:46 pm

JoMoney wrote:
Thu Oct 18, 2018 5:33 pm
Regarding the S&P 500 index Total Return, an interesting factoid is that there are a couple different S&P 500 Total Return indexes that represent different periods where the 'Total Return' index followed a different scheme reinvesting dividends
http://www.cftech.com/index.php/the-bra ... alculation
... There are four different total-return indices for the Standard & Poor's 500 Index: 1936, 1970, 1988, and year-to-date. Each one uses a different base period. The 1936 and 1970 total return indices were developed for historical use. Dividends are reinvested quarterly from 1936 through 1988 in the 1936 total-return index, and dividends are reinvested monthly from 1970 through 1988 in the 1970 total-return index. The 1988 total-return index is calculated based on daily reinvestment of dividends and uses January 1, 1988, as the base period. The year-to-date total-return index is also calculated assuming daily reinvestment of dividends; however, the base period is the last day of the prior year...
Very interesting information! Thank you.
"To play the stock market is to play musical chairs under the chord progression of a bid-ask spread."

alex_686
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Re: What do index funds do when firm's market cap drops?

Post by alex_686 » Thu Oct 18, 2018 5:50 pm

To add a bit to JoMoney's post, yes dividends are reinvested back into the index. This is important. When a company.issues a dividend its market cap drops. You have to reinvest the dividend to keep the index at market cap.

A good example - IIRC - is back during the 90s when Microsoft issued a special one time dividend or $8. This was one of the biggest comapanies kicking out about 20% of its market capital in a big dividend.

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Re: What do index funds do when firm's market cap drops?

Post by triceratop » Thu Oct 18, 2018 6:07 pm

Not that anyone is keeping score, but that was my point.

It's a good point that this discussion of reinvestment of dividends by mutual funds/ETFs is tied directly back to the OP's question since otherwise market cap would drift during the year, before distributions by the mutual funds/ETFs would be (for the most part) reinvested back in at market cap. That's now how anyone expects these funds to work, and it isn't.
"To play the stock market is to play musical chairs under the chord progression of a bid-ask spread."

abc132
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Re: What do index funds do when firm's market cap drops?

Post by abc132 » Thu Oct 18, 2018 6:09 pm

triceratop wrote:
Thu Oct 18, 2018 5:05 pm
Earl Lemongrab wrote:
Thu Oct 18, 2018 3:47 pm
abc132 wrote:
Thu Oct 18, 2018 1:15 am
If a company pays dividends, and those dividends must be reinvested in weighted portfolio, would the top performers receive a benefit from the dividend payers?
Dividends are not reinvested in typical mutual funds or ETFs. They are distributed to the shareholders.
This is not exactly true. Dividends are reinvested in typical mutual funds or ETFs. However, an equal amount is also distributed regularly as dividends to mutual fund shareholders on a periodic schedule. So, you might reasonably ask: "well, isn't that not actually reinvesting the dividends, if they are being distributed?" And, no, in the interim (up to a quarter, half-year, or full-year depending on distribution schedule) the dividends are typically reinvested so that the overall return of the fund tracks the compound total return of the index. If the funds didn't reinvest dividends they would lag their benchmark.
I was thinking more in terms of people that automatically reinvest dividends, but the question is still the same (I'm not sure I understand the answer yet). Let's say a index fund initially worth $1000 pays 2% dividends, and company XYZ is 5% of the index, but pays no dividends.

When people automatically reinvest dividends, does that transfer money paid by dividend paying companies in the index into company XYZ, inflating it's price? I'm curious if non dividend paying companies benefit in any way from the dividend paying companies in their index due to automatic reinvestment (particularly large market cap companies without dividends).

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Re: What do index funds do when firm's market cap drops?

Post by JoMoney » Thu Oct 18, 2018 6:20 pm

Any new contribution to a market-cap index (dividend reinvestment or other contribution), is distributed across the entire market proportionately.
To the extent that non-dividend paying stocks are purchased, dividend paying stocks are also purchased... by weight..., and distributed across the entire market.
Whether or not it's a "benefit" to one group of stocks or another would depend on if you could show one group was over priced and the other under priced.
"To achieve satisfactory investment results is easier than most people realize; to achieve superior results is harder than it looks." - Benjamin Graham

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Re: What do index funds do when firm's market cap drops?

Post by alex_686 » Thu Oct 18, 2018 6:37 pm

abc132 wrote:
Thu Oct 18, 2018 6:09 pm
When people automatically reinvest dividends, does that transfer money paid by dividend paying companies in the index into company XYZ, inflating it's price? I'm curious if non dividend paying companies benefit in any way from the dividend paying companies in their index due to automatic reinvestment (particularly large market cap companies without dividends).
Most funds automatically reinvest their dividends internally daily. Assume the index is the S&P 500. So when company X pays a dividend, that dividend gets chopped up 500 ways and is used to purchases all 500 companies. You might say that artificially props up non-dividend company XYZ. I would not. But that is almost another question on how fairly markets price stock.

When a mutual fund pays and reinvests a dividend, that is strictly a internal paper transaction. The only reason why mutual funds pays dividends is so that there is a taxable transaction so you know what to pay the IRS.

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Re: What do index funds do when firm's market cap drops?

Post by abc132 » Thu Oct 18, 2018 8:06 pm

alex_686 wrote:
Thu Oct 18, 2018 6:37 pm
abc132 wrote:
Thu Oct 18, 2018 6:09 pm
When people automatically reinvest dividends, does that transfer money paid by dividend paying companies in the index into company XYZ, inflating it's price? I'm curious if non dividend paying companies benefit in any way from the dividend paying companies in their index due to automatic reinvestment (particularly large market cap companies without dividends).
Most funds automatically reinvest their dividends internally daily. Assume the index is the S&P 500. So when company X pays a dividend, that dividend gets chopped up 500 ways and is used to purchases all 500 companies. You might say that artificially props up non-dividend company XYZ. I would not. But that is almost another question on how fairly markets price stock.

When a mutual fund pays and reinvests a dividend, that is strictly a internal paper transaction. The only reason why mutual funds pays dividends is so that there is a taxable transaction so you know what to pay the IRS.
I can see that if at dividend payout time to customers, the shares are sold in proportion to the index representation to make the dividend payments, and any repurchases are at the same ratio, there is no change at dividend payout time total value for those that reinvest, or for proportion of each company for those that take payments or reinvest.

But I also see that daily dividend repurchases are being used to purchase company XYZ on a daily basis. I think you are making the point that any "advantage" from repurchases would already be priced into the market, say through prior earnings reports and expectations. If I have wrapped my head around this, a company with a large market cap and no dividends could be "benefiting" from this repurchasing, but the benefit might not pass on to me if it is already priced into the market.

Thanks everyone!

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