Navigating index rebalancing effects: Key insights for smarter execution

Over the past two decades, passive investment strategies have become an integral part of global capital markets, complementing active management, and helping investors achieve a range of objectives. While active strategies seek to deliver alpha by outperforming benchmarks through security selection and market timing, passive strategies offer broad market exposure, cost efficiency, and transparency. Both approaches are integral to portfolio construction, whether implemented through a core-satellite model or a diversified total portfolio approach. Their coexistence reflects the evolving needs of institutional and intermediary investors.

The rapid growth of passive investing, alongside the widespread adoption of exchange traded funds (ETFs), has significantly reshaped market dynamics. By the end of 2024, total net assets in ETFs reached $14.85 trillion¹, highlighting the scale and influence of index-tracking vehicles in global markets. This expansion has introduced new structural features into equity markets, including more predictable trading patterns and implementation frictions that can influence short-term price movements, particularly around systematic events such as index rebalancing.

Index rebalancing is one of the most significant systematic events in today’s equity markets. When index providers like MSCI announce benchmark changes, passive funds are required to rebalance their portfolios at the market close prior to the new index taking effect. This index reconstitution process can create temporary supply-demand imbalances for stocks with changing weights, presenting both risks and opportunities for market participants.

As a manager of both active and passive strategies, we recognise the importance of understanding these dynamics, not only to optimise execution and minimise costs for passive portfolios, but also to identify opportunities for active strategies to add value in the face of predictable market flows.

The impact of index rebalancing is based on a set of core principles that influence how markets respond during rebalancing events.

First, the price pressure hypothesis suggests that large, predictable trades associated with index changes can temporarily push prices away from fundamental values. Research shows that stocks targeted by hedge fund arbitrage strategies tend to outperform their peers by 0.86% per month before rebalancing events², demonstrating how informed traders can anticipate and capitalise on these mechanical flows.

Second, the market efficiency hypothesis suggests that developed markets with greater active trading tend to have smaller and shorter-lived price distortions. In contrast, for markets where there are fewer active traders, and lower liquidity, price distortions from index rebalancing can be larger and persist for longer periods.

Separately, there are transaction costs involved for passive funds given the requirement for these funds to trade in response to index changes at a fixed time. These costs are not necessarily visible when comparing an index fund’s returns to its benchmark as they are embedded in the performance of the indices.³

While extensive research has examined these dynamics in developed markets, there remains relatively limited coverage of developing markets, particularly in Asia Pacific ex-Japan (APxJ). This research gap is increasingly relevant as Asian markets grow in importance within global portfolios and exhibit unique characteristics, such as lower liquidity and efficiency.

As experts in Asia, we aim to address this gap by providing a comprehensive analysis of index rebalancing dynamics across major global regions, with a particular emphasis on APxJ markets. Our analysis goes beyond price impact patterns to explore optimal execution strategies tailored to varying market conditions. As a result, we are able to quantify the opportunities available to active managers seeking to exploit these inefficiencies and passive managers seeking to minimise implementation costs. This empowers investors to make more informed decisions and unlock potential “technical alpha” arising from predictable flow dynamics.

Perfomance dynamics

Our analysis reveals consistent patterns of temporary price pressure around index rebalancing dates across all regions, with notable variations in magnitude and persistence.

Fig 1 illustrates the average weighted active returns of upweighted versus downweighted stocks across four regional indices, aggregated over all rebalancing points since 2020. The vertical black dotted line marks the index rebalance date (i.e. the actual trade date, 0 day on x-axis), while the vertical blue dotted line marks index effective date (typically the market-on-close price on the effective date).

In most markets, we observe a recurring pattern whereby upweighted stocks outperform their respective country benchmarks relative to downweighted stocks in the days leading up to the rebalancing date. The effect is particularly pronounced in APxJ markets, where upweighted stocks exhibit a sharp spike in performance relative to downweighted stocks around the rebalancing window, followed by swift reversals.

Fig. 1. Average active returns of upweighted vs downweighted stocks on index rebalancing dates since 2000

Source: Data from MSCI & Eastspring Investments

This behaviour suggests a greater degree of market inefficiency in APxJ compared to more developed markets such as the US and Japan, where active market participants and liquidity providers are more effective in anticipating passive flows. This effect has shown remarkable consistency over time across APxJ, Japan, and US markets.

Fig 2 presents cumulative weighted active return spreads for each rebalancing period, offering a time-series view of the persistence and magnitude of these patterns. In contrast, MSCI Europe shows less consistent patterns, reflecting the complexity of its multi-country, multi-currency composition and fragmented market structure.

Fig. 2. Cumulative active returns of upweighted vs downweighted stocks on all index rebalancing dates since 2020

Source: Data from MSCI & Eastspring Investments.

The patterns reflect supply-demand imbalances from passive funds rebalancing at close of the prior day before index changes are effected, driving predictable buying and selling pressure. In markets with fewer active arbitrageurs, such as APxJ, this pressure often leads to pronounced price dislocations.

This imbalance is due to the closing auction on the day before the index change to align with the index calculation methodology. Passive managers, aiming to minimise tracking error, concentrate trades at the close, often overwhelming liquidity especially in less liquid markets.

Post rebalancing performance varies by region; in the US and Japan, upweighted stocks often outperform modestly due to ongoing fundamentals and a broader base of marginal buyers following their index inclusion, while downweighted ones slightly lag due to selling pressure from passive funds exiting positions. In contrast, APxJ and Europe typically show rapid mean reversion, indicating that initial price moves are driven more by temporary liquidity effects than fundamentals, reflecting the short-term dislocations from concentrated passive flows.

Execution outcomes

Our analysis shows that the market impact of passive flows during closing auctions on index rebalancing dates varies by region. We assess execution performance by comparing weighted average price differences across benchmarks such as Time Weighted Average Price (TWAP) and Volume Weighted Average Price (VWAP) versus the traditional close execution. These benchmarks are measured at various times during the trading day (e.g., near open, intraday, near close), with weights normalised based on each stock’s index weight change to ensure comparability.

As shown in Fig 3, close execution outperforms other benchmarks in Europe and Japan, suggesting that even with elevated volume, closing auctions effectively absorb large rebalancing flows. This may reflect these markets’ ability to match passive flows with sufficient counterparties during the closing auctions. In contrast, close execution underperforms in the US and APxJ, indicating that concentrated trading at the market close imposes significant market impact costs. This suggests that spreading trades throughout the day or using alternative execution strategies could improve implementation performance.

Notably, this result is somewhat counterintuitive: while the US is highly efficient and APxJ is more fragmented, both require highly tailored execution solutions to manage rebalancing flows effectively. In the case of the US, this may reflect the influence of its large and diverse ETF market, where many vehicles do not require strict market-on-close execution like traditional index funds. Additionally, sophisticated institutional investors may deliberately avoid crowded closing auctions, further diluting the effectiveness of close-based execution.

Fig 3: Performance comparison across execution benchmarks on index rebalancing dates

Source: Data from MSCI, LSEG & Eastspring Investments

Regional differences in execution outcomes can be attributed to several factors: variations in market structure, the presence of active and sophisticated arbitrageurs, differing liquidity patterns in markets, and time zone effects. Markets with robust auction mechanisms and active participants are better equipped to absorb predictable passive flows, while markets that close during active trading hours in other major regions may benefit from cross-border arbitrage and broader liquidity.

Index rebalancing effects are a persistent feature of modern equity markets, varying significantly by region and market structure. As passive investing continues to grow, understanding its market impact is increasingly vital for both active and passive managers. While passive strategies offer cost efficiency and broad diversification, they also introduce challenges that demand adaptive, region-specific approaches.

Our findings highlight how systematic trading from passive flows creates predictable supply-demand imbalances, leading to both risks and opportunities that investment professionals must navigate in today’s complex and interconnected markets. Furthermore, the regional variations in optimal execution strategies highlight the importance of adapting implementation approaches to local market characteristics rather than applying a uniform global strategy.

These documented market impacts raise broader questions about index design and rebalancing practices. Simple rules, such as trading ahead of index funds or delaying reconstitution trades by 3 to 12 months, can add up to 23 basis points a year⁴. Index providers may wish to consider modifications that reduce market impact while preserving index integrity.

Our findings offer actionable guidance for passive manager seeking to optimise trade execution strategies. In markets where close execution underperforms, managers should consider:

• Spreading trades across multiple time periods
• Using TWAP or VWAP strategies over extended periods
• Leveraging opening auction mechanisms where appropriate
• Implementing gradual accumulation strategies in the days leading up to the rebalance

The supply-demand imbalances created by index rebalancing events represent meaningful opportunities for both active and passive managers as summarised in Fig 4.

Fig. 4. Actionable guidance for active and passive managers

Source: Eastspring Investments

The pronounced effects observed in APxJ markets, relative to more developed markets, suggest that market development and arbitrage infrastructure play key roles in determining the magnitude of index rebalancing impacts. As these markets continue to evolve and attract more sophisticated participants, it is reasonable to expect the observed effects may moderate over time in line with the principles of efficient market theory. However, the ongoing expansion of passive strategies, particularly in emerging markets with less developed arbitrage infrastructure, suggests that these dynamics will remain relevant for the foreseeable future.