In real estate you'd call it investing via a gentrification strategy. Lets say in a net inflow market where the net flow is going in and supply (of new stocks) isn't keeping up with demand, you buy company A B and C and greater supply/demand effects (plus inflation, I suppose) mean they all go up, A goes up 10%, B 20%, C 30% and your investment strategy is to own equal dollar values of A B and C.
Perhaps A is large caps, B is small caps, and C is metals, it don't really matter for the sake of discussion.
You started off with purchases equal to your 33% 33% 33% goal ratios but after a year of unequal growth you're overweight C and underweight A.
Active rebalancing is selling enough C and buying enough A to get roughly equal ratios of A:B:C.
Passive rebalancing is if you're contributing $5K IRA per year or whatever, dump all your contributions into underweight A. Or whichever is underweight at any time.
Basically if your position ratios don't match your goal ratios, if you're selling thats active rebalancing and if you're merely changing the ratio of what you buy because you're a net investor thats passive rebalancing.
Going back to the real estate analogy dumping money into purchasing a lot in a gentrifying neighborhood is an analogy for passive rebalancing. If you sold your best performing property to fund it, that analogy would be active rebalancing.
VLM wrote about it excellently from the buyer's side, but I was thinking about it more from the market side.
Depending on the weighting method of the index you're tracking (and other indices that include your stocks), the indices need to rebalance purely in response to "price changes happened and reallocation is needed."
This requires buying at minimum (or buying and selling as VLM pointed out). That buying moves the market when there's a significant amount of money in index following funds.
The initial comment was about reaping arbitrage when (I think) the price the index following funds made diverges from the actual (ex index involvement) price.
I was wondering how that's operationally relevant or whether the "Don't fight the Fed" rule comes in, given that there's a massive amount of money in index funds.
Someone with more knowledge would have to chime in as to the effect in aggregate of rebalancing playing against active moves (for fundamental reasons).
Passive trackers do not need to rebalance in response to price changes when full replication is used, at least for market-cap weighted indices (I know there are also indices which are not exactly market-cap weighted and rebalance a few times per year, and of course some trading is required when the composition changes).
I think the relevant mispricing introduced by passive investing is the relative one. The question is not that passive investors are driving the S&P 500 index higher than it should. The thing is that they are failing to distinguish company A, which should ouperform because it's doing well, from company B, which should underperform because it's not doing so well.
Perhaps A is large caps, B is small caps, and C is metals, it don't really matter for the sake of discussion.
You started off with purchases equal to your 33% 33% 33% goal ratios but after a year of unequal growth you're overweight C and underweight A.
Active rebalancing is selling enough C and buying enough A to get roughly equal ratios of A:B:C.
Passive rebalancing is if you're contributing $5K IRA per year or whatever, dump all your contributions into underweight A. Or whichever is underweight at any time.
Basically if your position ratios don't match your goal ratios, if you're selling thats active rebalancing and if you're merely changing the ratio of what you buy because you're a net investor thats passive rebalancing.
Going back to the real estate analogy dumping money into purchasing a lot in a gentrifying neighborhood is an analogy for passive rebalancing. If you sold your best performing property to fund it, that analogy would be active rebalancing.