How To Think About Reconstitutions

February 04, 2015

The Virtues Of ‘Packeting’

CRSP may have gotten somewhat wise to this, however, as it’s introduced the concept of “packeting.”


To quote the methodology document:


“Once a security crosses through the band between its current style placement and the other one, 50 percent of its holdings are moved. If the security stays beyond the threshold in the following ranking period, the remaining 50 percent will be moved. Therefore, a security may be partially held in both a value and a growth index.”


In other words, as the security changes style, at least 50 percent of the position will be held for another quarter. Assuming that crossing from value to growth implies at least some appreciation in value, then at least we hold on for another quarter.


While I think packeting is a step in the right direction, I believe it still falls short.


Value Extraction Re-examined

If we believe the value premium, broadly, takes at least a year to mature, then we should hold that security for at least a year. To do this, we would employ “tranching.”


Quarterly tranching would be implemented by using 25 percent of your portfolio to buy each quarter’s vintage and then rolling over that vintage every year. So today your portfolio would comprise the March 2014, June 2014, September 2014 and December 2014 value portfolio vintages.


At the end of March, we’d roll the March 2014 vintage portfolio into a new March 2015 vintage. This methodology gives us the benefit of diversifying across vintages without sacrificing the need to allow the vintage to mature.


This tranching technique is actually something we employ at Newfound in our tactical portfolios, but over a shorter time horizon.


We believe that the momentum premium we are tracking takes about one month to mature. So, while we reconstitute our portfolios weekly, the reconstitution merely rolls one of the four weekly vintages over, allowing each vintage a full month to mature.


In Search Of New Ways To Reconstitute

Unfortunately, there’s not a single index provider or ETF issuer I am aware of that incorporates the tranching concept in reconstitution, though there are other ETF strategists that do.


Nevertheless, in some cases, we may actually be able to proxy this methodology on our own.


For example, the iShares S&P 500 Value ETF (IVE | A-91) tracks the S&P 500 Value Index, which also reconstitutes on an annual basis, but does so in December. While the underlying S&P-based value definition differs from Russell’s, using IWD and IVE in tandem may allow us to diversify not only our methodology risk, but also our vintage risk.


Reconstitution is not a sexy topic by any means, but it can have a massive implication for how your portfolio performs.


While these examples have been limited to value portfolios, reconstitution affects almost all strategic, tactical and fundamentally based portfolios that are available today.


My advice: Don’t overlook reconstitution in your due diligence process.



At the time this article was written, the author’s firm owned shares of IWD on behalf of clients.

Newfound Research LLC is a Boston-based quantitative asset management firm focused on rules-based, outcome-oriented investment strategies. Newfound specializes in tactical asset allocation and risk management solutions. Founded in August 2008, Newfound offers a full suite of tactical ETF managed portfolios covering global equity, U.S. small-cap equity, multi-asset income, fixed-income and liquid alternative asset classes. For more information about Newfound Research LLC, call us at 617-531-9773, visit us at www.thinknewfound.comor email us at [email protected]. For a list of relevant disclosures, click here.




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