ETF: When companies fall out of the index

An ETF is made up of investments in a number of different companies. Many investors worry about the impact of the performance of a single share on the performance of the ETF. This is especially of concern in an ETF weighted by market capitalisation, where bigger companies have a bigger impact on the price movement of the ETF.

The horrific collapse of Steinhoff, which was still a Top 10 constituent of the Top 40 index this time last year, provides a great opportunity to see what happens to an ETF when one of its constituents falls from grace.

By 30 June last year, Steinhoff represented 3.21% of the Top 40 index. At the time, the value of one Satrix 40 ETF unit was 4595c*. Steinhoff’s 3.21% contributed 147.5c to each ETF unit. If no other constituents had entered the Top 40 and Steinhoff had been booted out right away, one Satrix 40 ETF unit would have been worth 4447c the day after the share price collapsed.

However, since ETFs are reweighted quarterly, the company continued to hold its weight in the Top 40 until September, at which point it fell out of the Top 10 holdings. It was once again reweighted in the Top 40 Index in December 2017, following the collapse of the share price.

By the end of December 2017, the company’s weight in the index had fallen from 3.21% to 0.3%. At the time, one Satrix 40 ETF unit was 5271c. The 0.3% Steinhoff weighting contributed 15.8c to the share price. For the sake of simplicity, we’ll round up to 16c. By Monday next week, Steinhoff would have fallen out of the Top 40 index completely.

The share price of an individual company can impact the share price of an ETF on a short-term basis too. Market capitalisation is determined by multiplying the number of shares in issue by the share price of each company. Companies are included in the index based on their size relative to other companies in the investable universe. Until the index is rebalanced at the end of each quarter, however, the weighting of an individual company stays the same.

Indices are compiled based on the share prices of each of the constituents on the day of reweighting. In the case of a share price disaster, the company’s weighting stays the same while the value of the shares fall. The value of index will fall proportionate to the share price movement and the weighting of the company within the ETF. Since ETF unit costs are determined at the end of the day, the share price movement will affect the unit price on the following day.

However large a single share price movement may be, it’s important to remember that the rest of the shares within the index all continue to move too. The share price movement of an ETF is therefore unlikely to only reflect the price movements of a single company.

Once a share falls out of the Top 40 index, it’s replaced by the share that was formerly in the 41st position. Last year, for example, Netcare, representing 0.57% of the index, fell out. It was replaced by rising-turned-shooting star Resilient Property Income Fund.

*While many would argue reporting share prices in cents is for the sake of accuracy, I maintain it’s for the sake of driving me mad.