The quarterly rebalancing of the S&P/ASX indices has just taken effect before market open on Monday, June 23.

This quarter’s S&P/ASX 200 Index rebalance includes two additions to the index: Austal Ltd. (ASX:ASB) and Nick Scali Ltd. (ASX:NCK), and two removals being Healius Ltd. (ASX:HLS) and Stanmore Resources (ASX:SMR).

On the surface these events - which take place quarterly to ensure index weights and constituents are calibrated to reflect changes in market capitalisation - are procedural. But beneath the surface, these adjustments can trigger significant shifts in liquidity, trading costs, and even performance outcomes - especially for investors anchored to index-tracking strategies.

Rebalancing vs. reconstitution: the differences

While often mentioned together, rebalancing and reconstitution are distinct process with different implications for portfolios. They take place on routine dates in a standard quarterly cycle observed each March, June, September, and December.

Reconstitution involves the addition or removal of companies from key benchmarks such as the S&P/ASX 200. For investors in index-tracking strategies such as ETFs or managed index funds, both actions can trigger mandatory trades. Constrained by the need to match an index, passive strategies can be locked or forced into certain trading activity around rebalancing and reconstitution events - with their volume and price pressure - that can hurt returns.

The hidden costs of ‘passive’ investing

While index funds remain a core allocation tool for many institutional portfolios, recent research from Dimensional Fund Advisors highlights a persistent and often underappreciated source of performance drag in passive strategies: implementation costs during index reconstitution.

Because index-tracking funds, by design, are required to adjust holdings in line with benchmark changes - often on specific dates and at specific times- they are often forced to buy or sell securities regardless of prevailing market conditions.

This lack of trading flexibility can result in material execution costs, particularly when trading volumes spike around reconstitution and rebalancing events.

Dimensional’s global research found that stocks added to an index typically see a price run-up in the 20 days prior to inclusion - averaging an excess return of 3.9% - only to reverse by 4.4% in the following 20 days.

Likewise, deletions tend to fall before removal, then rebound after. In essence, index funds are often compelled to buy high and sell low, locking in unfavourable prices due to their need to match index holdings and minimise tracking error.

This inefficiency is compounded by the way index trades cluster at the close of trading on reconstitution days. Dimensional’s data shows that the largest share of reconstitution trading activity occurs in the final seconds before the closing auction, when prices are most distorted, and liquidity is stretched.

Australia rebalancing can increase trading volatility

The costs of rebalancing events to investors are even more pronounced in smaller, more concentrated markets like Australia’s.

A 2025 global study by Dimensional Fund Advisors, reviewed the costs of index reconstitution from 2014 to 2023 for five widely tracked indices outside the US: FTSE 100, S&P/TSX 60, S&P/ASX 300, EUROSTOXX 50, and Nikkei 225.¹

It found Australia’s S&P/ASX 300 as one of the most impacted by price dislocations and volume spikes on rebalancing days.

Trading volumes on the ASX 300 can spike up to 149 times normal levels on reconstitution days - making it one of the most volatile among the global indices they analysed.

Dimensional found this can lead to meaningful trading costs for index-tracking funds, particularly when they are forced to trade in the closing auction to minimise tracking error.

That dynamic hasn’t gone unnoticed by active managers. Forager Funds, one of the country’s best-performing equity managers over the past year, has spoken about how inclusion in an index generates momentum and attracts investor attention.

Identifying those smaller companies that can become future index constituents has been particularly fruitful strategy for Forager, according to CIO Steve Johnson.

In a January 2025 Livewire article, Johnson highlighted several Forager holdings - Gentrack (ASX:GTK), RPM Global (ASX:RUL), Flutter Entertainment (ASX:FLTR), and Ferguson (ASX:FGN) - as companies that have recently benefited from index inclusion, or anticipated inclusion.

Implications for investors

For advisers and sophisticated investors, the latest ASX rebalancing is a reminder that passive investing can carry active implications. Index changes can distort prices and trigger costly, forced trades - costs not reflected in expense ratios. These events present both risks and opportunities, underscoring the value of advised oversight when it comes to portfolio decision-making.

With the latest rebalancing having just taken effect, they are timely dynamics to be aware of.

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¹ Dimensional Fund Advisers, Measuring the Costs of Index Reconstitution: Evidence Outside the US