Rebalancing 101

Rebalancing is the process of reviewing the stocks/ETFs & their weights of a smallcase to ensure that it remains true to the theme or strategy. Rebalancing takes into account quarterly earnings, company news & updates, etc and uses proprietary algorithms to objectively narrow down on the right set of stocks.

This article on rebalancing will cover:
1. Understanding rebalancing
2. Impact of rebalancing on P&L
3. Frequently Asked Questions

Understanding rebalancing

Human nature conditions us to take actions based on external or internal factors to adapt to the changes around us. Now let’s apply the same logic to a smallcase.

A smallcase is a basket of stocks that is aligned with a market theme/idea/strategy. To adapt to the changing market conditions, most smallcases are rebalanced on a quarterly basis to ensure that the constituents of a smallcase are the right choice for taking exposure to a particular theme.

Let’s take the example of a football team – there would be 10 players at any given point, playing on behalf of a team. However, as the match goes on, substitution happens along the way – some players are asked to retreat and another player is sent in their place, for various reasons. Although the individual players who are part of the team would be changing, the team that they are playing for still remains the same.

Similarly, if a stock is no longer a match for the strategy criteria, it would be removed from the smallcase at the time of rebalancing and any new stocks that do fit the criteria would be added to the smallcase, however, the theme of the smallcase remains the same. Moreover, rebalancing is done to ensure that the stocks in a smallcase are aligned with the theme. Most of the smallcases are rebalanced on a quarterly basis.

Let’s see this in action using sample criteria:

 Criteria of a smallcase:

• Select top 500 companies as per market capitalisation
• Select companies with a PE ratio > 20

If a stock fails to meet the criteria, it would be removed from the smallcase. New stocks that are in accordance with the criteria would be added to the smallcase.

Let’s simplify this using the example of the football team

Criteria for a player:

• Select players in white jerseys
• Select players with odd numbered jerseys

Before rebalancing

After rebalancing

Player 73 in a grey jersey, players 10 and 22 (even numbers) who didn’t match the criteria were removed and new players 05, 57 and 85 who fit the criteria, were sent in their place.

In the same fashion, stocks that no longer fit the original criteria would be removed and new stocks that fit the criteria would be added to the smallcase at the time of rebalancing. If one has invested in a smallcase, these changes would be sent as a rebalance update, that can be reviewed and applied in 2 clicks.

If during the review, it is found that the existing constituents & their weights of a smallcase will continue to hold good for the next cycle, no changes will be pushed in the rebalance update.

Impact of Rebalancing on Investment Details

Let’s say you receive an email on 1st of March stating that your smallcase has a rebalance update. To checkout the same, you login to the platform and before rebalancing the smallcase you check the details section. This is how your details section would look before rebalancing:

You notice that you are making a total profit of Rs 2731.25 – 5.19% of the money put in by you in the smallcase. You check out the rebalance update and say, it says that SJVN has been removed and Hero Motocorp has been added. To apply the changes you go the Manage section and click on Apply Update.

When you rebalance a smallcase, two things happen:

• Stocks which got removed from the smallcase are sold and stocks which got added are bought
• We try to move the weighting scheme as close as possible to the prescribed weighting scheme

We make the above changes while ensuring that we minimize the rebalance cost for you. Let’s say the following happens during the rebalance

In the above table, you can see that all the 28 shares of  SJVN were removed from the smallcase and 6 shares of Hero MotoCorp were bought. 5 shares of KPIT and 14 shares of Gujrat Alkalies were sold as well, to correct the weighting scheme

As explained earlier, whenever you sell shares, you either book profit or loss. If the price at which you are selling the stock is more than the average buying price, you book profit – as on an average, current price of each share is more than the price at which you bought it. Let’s look at the KPIT row and understand each of the element

In the rebalance you sold 5 shares of KPIT at the current price of 268.5. You can check the current price in the Investment Overview above. Amount sold = 268.5 * 5 = 1342.5. Also the selling price of 268.5 was more than the average buying price of KPIT – Rs 258.92. Thus, you booked profit equivalent to (268.5 – 258.92) * 5 = 47.91. It is simply the profit made on each share multiplied by the number of shares sold. The average buy price was 258.92, thus your investment in the 5 shares of KPIT which you sold was Rs 1294.59 (258.92 * 5) and you have taken out this investment

In total, you booked a combined profit of Rs 139.49 on all the stocks and took out an investment of 15611.11. Note that if you add both the figures: 139.49 + 15611.11, you will get 15750 which the total selling amount. This makes sense as the total sell amount will be equal to your investment plus any profits or loss. As you can see the amount invested is Rs 3318.3 which is higher than the amount sold and will thus increase the total money put in by this amount.  This is how the investment overview will look after the rebalance.

As you can see, the Money Put In increased by Rs 3318.3 which is the extra investment made by you in the trade. Another interesting thing to notice is that total P&L of Rs 2731.25 remained the same, before and after the rebalance. It’s just that you booked Rs 139.49 out of Rs 2731.25. Also the total P&L % came down a little bit, because you put an extra Rs 3318.3 on which you haven’t yet made any money (the same thing which happened after investing more)

Frequently Asked Questions:

Are rebalance updates applied automatically?
Rebalance updates are not applied automatically. You would be notified via email when a smallcase you have invested in has a rebalance update available. You can review the changes and apply the update in 2 clicks.

What happens if I don’t rebalance my smallcases?
Applying rebalance updates isn’t mandatory so you may skip them. However, if you skip the update, the composition & returns for your smallcase may vary from the original.