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ETF Rebalancing: An Issue Not To Be Overlooked

|Includes: PBJ, PEP, SBUX
One of my favorite things to do in this weekly column is to address themes from the ETF universe that I believe are relevant to everyday investors and that are either misunderstood or ignored completely by traditional financial media outlets. I'm going to address one such theme this week and it is near and dear to my ETF heart: ETF rebalancing.

The concept is simple to understand. Investors know that when they buy a traditional long equity-based ETF that the fund tracks an underlying index and that the ETF attempts to track the index as closely as possible by weighting its equity holdings in similar fashion to that of the index. Yes, there are examples where ABC Inc. may account for 10% of the underlying index and 9.8% or 10.1% of the ETF, but rarely will you find significant discrepancies.

Moreover, it is important that investors realize that even passively managed ETFs do rebalance periodically. While an actively managed ETF may rebalance on a quarterly basis, or even more frequently, a regular passively managed ETF might rebalance on an annual or semi-annual basis. Regardless of the frequency of rebalancing, investors will want to stay abreast of such activity.

One of the best things about ETFs is their transparency. Finding out what stocks an ETF holds is easy as going to issuer's Web site and punching in the ETF's ticker, but for some reason and I've actually been spending a fair amount of time recently talking with ETF issuers trying to figure out why, rebalancing is not publicized by ETF sponsors.

It's not that issuers are trying to keep secrets, but they're certainly not bragging rebalancing either. Here's a great example: The Market Vectors Coal ETF (NYSE: KOL) recently rebalanced to reflect the completed purchase of Massey Energy by Alpha Natural Resources (NYSE: ANR). Give or take a couple tenths of a percent, Alpha Natural basically absorbed Massey's weight in KOL.

This is par for the course regarding how M&A activity can impact an ETF's allocations to individual stocks, but sometimes indexes rebalance to include bigger weights to new components and lesser weights to older components or exclude older names altogether. For example, just a couple of weeks ago, PepsiCo (NYSE: PEP) and Starbucks (Nasdaq: SBUX) combined for roughly 10% of the PowerShares Dynamic Food & Beverage ETF (NYSE: PBJ). As of June 7, those stocks are nowhere to be found among the ETF's holdings.

All of this is my round-about way of saying that a lot of traders and investors, myself included, use ETFs as proxies for or exposure to certain stocks without having to own that stock outright. If the ETF we're using for that purpose rebalances and it affects the weighting to stock that motivated us to get involved with the ETF to begin with, the outlook for our trade has to change as well.

Along those same lines, if the stock disappears from the index, and thus the ETF altogether, we don't want to be caught off guard by this event. Long story short, I don't think there this any empirical evidence to suggest that ETF rebalancing hurts investors, but as I've said many times in the past when it comes to ETFs five minutes of homework can help avoid an hour of headaches.

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