Index funds are a preferred way of investing in the stock market, as they are usually less volatile than investing in individual stocks. Individual stocks often encounter stock splits and reverse stock splits under certain market conditions. But, are there occasions when index funds are subject to similar changes?
Index funds do stock splits and reverse splits based on market conditions. However, such splits happen less frequently with index funds than individual stocks. Index fund splits function similar to stock splits; one share is split proportionally, and the shareholder keeps the total value.
Keep reading as l further discuss index funds and stock splits. Index fund splits can be driven by a variety of market conditions. Further in this article, we will explore these different market conditions that encourage stock splits further, in addition to the fundamentals around index fund stock splits. So, without further ado, let’s begin!
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Table of Contents
How Index Funds Stock Splits Work?
Index funds do experience stock splits. These splits function similar to stock splits but are done less often. Additionally, similar to stock splits of individual stocks, index fund stock splits do not affect the value of one’s investment.
Mutual fund managers can use their judgment in deciding whether or not to split up the stocks of a given index fund into multiple shares. This is known as “stock splitting,” but there is no fixed pattern that all (or even most) index funds follow regarding when they will execute this type of move.
Sometimes index funds will split shares when a security within their portfolio is undergoing stock splits. On other occasions, it can be some other miscellaneous reasons. In essence, it simply comes down to each specific manager’s discretion on any given day.
Number of Shares Change in a Stock Split, Not Their Worth
Although the number of outstanding shares rises after a stock split, the overall value of those shares remains the same as before because no real value is added or removed from the portfolio.
When a stock split is implemented, the price of shares adjusts automatically in the marketplaces. The board of directors at a company determines how many ways, or in what ratio, to split the index fund stock.
The Most Common Stock Split for Index Funds Is a 2-for-1 Split
With a 2-for-1 stock split, a share price is cut by half. Each share is divided into two. Shareholders in the company double their holdings of shares. A 2-for-1 stock split does not cause your portfolio’s value to drop.
A stock split doesn’t affect a company’s total value (also known as market capitalization or “market cap”). It just doubles the number of shares outstanding. Existing shareholders not only get to double their holdings but the number of available, unsold shares doubles as well.
The company’s stock price will be lowered. More shares will be available, which will attract a larger demographic of investors. The goal is to get as many people as possible to acquire the company’s stock.
The most common split type is a 2-for-1 stock split, but there have been many different kinds throughout the stock market’s history. There are no hard and fast rules about how a stock split may be structured. A company can utilize:
- 3 for 1
- 3 for 2
- 4 for 1, or
- 10 for 1 in any combination they choose.
Reverse Stocks Can Also Affect Index Funds
A reverse split works in the opposite way of a conventional split, and can affect index funds the same way that regular splits do. Reverse splits should be taken with a grain of salt. When a stock’s price becomes so low that the company does not want it to appear like a penny stock, they sometimes implement a reverse split.
When performing a reverse stock split, a given company will reduce the number of total shares by the proposed amount while increasing the value.
For example, if a company has 100 shares total valued at $5 each, they could perform a reverse stock split, giving them 50 total shares at $10 each. Reducing the number of shares is done to increase the perceived value of single shares and is often a sign of a company in distress.
A reverse stock split is when a company’s outstanding shares are divided by a number, such as 5 or 10, resulting in a smaller number of shares. It can also be known as a:
- Stock consolidation
- Stock merger
- Share rollback
They’re the inverse operation of a stock split, in which a single share (split) is broken into multiple pieces (shares).
When Do Index Funds Do Stock Splits?
Since 1980, the average number of stock splits each year on the S&P 500 index has been 44.68 total, according to data from S&P Dow Jones Indices. The highest was in 1986, when there were 114 splits, while the lowest came in 2017, when only 5 splits occurred.
When looking at stock splits, we need to look at the market. There are 2 classifications of the stock market: Bear vs. Bull.
Index Funds Split More Frequently in Bull Markets
In bull markets, index funds and stocks split more frequently. Bull markets happen when investors feel confident with what is happening in the economy and with companies’ operations. As stock splits tend to indicate a bullish market, index funds will also attempt to split their shares when the outlook is optimistic.
Investors are more confident when the value of investments continues to rise for extended periods during bull markets. Investors are eager to acquire or keep stocks because of the strong economies and low unemployment that usually accompany bull markets.
Index Funds Split Less Frequently in Bear Markets
The reverse is true in bear markets, which occur when stock prices fall 20% or more over a lengthy period. Bulls are usually powered by economic vitality, whereas bear markets are generally sparked by economic recession and increased unemployment.
Instead of wanting to get back into the market, investors want to sell off their assets, frequently seeking refuge in cash or fixed-income securities. As a result, there’s a seller’s environment.
While index funds aren’t likely to split in bear markets, there may be occasions where they do so anyway because of an anticipated change in investor sentiment. On these occasions, however, index fund investors should take caution and carefully consider whether or not it makes sense for them to sell all or part of their holdings at this time.
Companies Use Stock Splits to Meet Goals or Minimum Requirements
In many situations, stock splits are techniques utilized by businesses to achieve a certain objective. Companies frequently prefer to make more liquidity by reducing the price to look more appealing and attainable to potential investors.
In contrast, reverse stock splits are frequently used to assist a company in meeting exchange listing requirements. You may be removed from an exchange if your price drops too low. Reverse stock splits consolidate shares in such a manner that they have a higher value for each share.
More investors can buy in, ensuring more people may get ahold of the stock and that existing shares remain liquid. Even though reverse stock splits are typically seen as a warning sign for shareholders, over time, it may assist a company in surviving and recovering from tough conditions.
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Conclusion
Index funds typically split at some point when the stock prices rise too high for investors to afford or keep them competitive. When an index fund splits, one share is divided proportionally, and shareholders can retain their total value.
For this reason, many avoid trading in these circumstances until trading resumes again on the next day following the split. If you are considering investing in an index fund now or later, make sure you read up on what happens during a stock split first! Here on TradeVeda, we have tons of articles to get you started on your investment journey!
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