It is possible for an existing ETF to remove one stock and add another, and this is a common practice in the ETF industry. This is known as a “rebalancing” of the ETF’s portfolio.
ETFs typically track a specific index, such as the S&P 500 or the NASDAQ Composite, and the index may periodically add or remove stocks based on certain criteria, such as market capitalization or sector representation. When the index makes changes, the ETF may need to rebalance its portfolio to reflect those changes.
Rebalancing typically involves selling some of the ETF’s holdings in the stock that is being removed, and using the proceeds to buy shares of the stock that is being added. This process helps to ensure that the ETF continues to track the index it is designed to follow.
There are some limitations on how often an ETF can make changes to its portfolio, and how much of the portfolio can be changed at once. For example, the SEC has established rules that require ETFs to disclose their policies and procedures for changing the composition of their portfolios, and to limit the frequency and magnitude of those changes.
Overall, adding and removing stocks from an ETF’s portfolio is a normal part of managing an ETF, and is done in order to ensure that the ETF continues to track its underlying index and provide investors with exposure to a diversified portfolio of stocks.
Example of Rebalancing
Let’s say the ETF holds the following stocks:
- Company A: 1,000 shares, trading at $50 per share
- Company B: 2,500 shares, trading at $75 per share
- Company C: 1,500 shares, trading at $25 per share
- Company D: 3,000 shares, trading at $30 per share
- Company E: 2,000 shares, trading at $60 per share
To calculate the NAV of the ETF, we first need to determine the total value of the portfolio. This is calculated by multiplying the number of shares of each stock by its current market price, and then summing the results:
Total portfolio value = (1,000 x $50) + (2,500 x $75) + (1,500 x $25) + (3,000 x $30) + (2,000 x $60) = $507,500
Next, we divide the total portfolio value by the number of outstanding shares of the ETF to get the NAV:
NAV = $507,500 / 10,000 shares = $50.75 per share
Let’s say that after the initial purchase of the stocks, the index that the ETF tracks decides to remove Company C and add Company F to its list of constituents. The ETF would then need to rebalance its portfolio to reflect this change.
Here’s how the rebalancing might work:
- Sell shares of Company C: Since Company C is being removed from the index, the ETF would need to sell all of its shares in that company. Based on the original example, the ETF held 1,500 shares of Company C, which were purchased for $25 per share. If the price of Company C has not changed, the ETF would receive $37,500 from selling those shares.
- Purchase shares of Company F: Next, the ETF would need to purchase shares of Company F to reflect its inclusion in the index. Let’s say that Company F is trading at $40 per share, and the ETF wants to purchase 2,000 shares to maintain the same weight in the portfolio. The ETF would need to spend $80,000 to purchase those shares.
- Adjust the weights of the other stocks: Since the addition of Company F changes the weightings of the other stocks in the portfolio, the ETF would need to adjust the number of shares it holds in each of those stocks to maintain the same overall weighting. For example, if the ETF previously held 1,000 shares of Company A, which represented 20% of the portfolio, it would now need to hold 1,000 shares of Company A and 2,000 shares of Company F, since those two stocks together represent 20% of the portfolio based on their new market values.
- Calculate the new NAV: Once the rebalancing is complete, the ETF would recalculate its NAV based on the new market values of the stocks in its portfolio.
Overall, this rebalancing process would involve selling some of the ETF’s holdings in Company C and using the proceeds to buy shares of Company F, while also adjusting the weights of the other stocks to reflect the changes in the index. The goal of the rebalancing is to ensure that the ETF continues to track its underlying index and provide investors with exposure to a diversified portfolio of stocks.
This page was last updated on March 31, 2023.