Many indexes around the world are the top X stocks on an exchange.
What happens when the bottom stock is overtaken by a stock that isn't in the index? Presumably, all of the funds that track that index would have to sell the replaced stock, artificially deflating its price while inflating the price of the stock added to the index. Surely this would be bad for the funds involved and cause dramatic swings in the value that were to happen?
What happens when the bottom stock is overtaken by a stock that isn't in the index?
Nothing really. What actually matters is what happens when an index is updated and a few companies are in/out. This kind of events depends on each particular index, but in most cases they get updated every three months or annually (see this example for all the historical changes in the FTSE 100)
Surely this would be bad for the funds involved and cause dramatic swings in the value that were to happen?
Again, it would depend on each case, but in most cases when a company falls out of the index it was already having a little weight over the whole set of companies in the basket (i.e. not all companies have the same weight in an index - the smallest companies in an index usually have very little relevance compared with the largest ones), so the swings should not be that large.
Note, however, that those kind of swings are actually very real if we talk about the entering/leaving company stock, instead of focusing on the ETFs (e.g. have a look at the stock price for Twitter in the NYSE or Ocado in the LSE in the past year).
What happens is that one stock will be removed from the index and replaced with another one.
This in itself is a non-issue, BUT....
...this is 2018. You have a plenthora of index tracking passive funds, which then have to sell the original stock (as it is not in the index anymore) and have to buy the replacing stock. This can lead to further at least temporary price distortion.
Note though that indices (and thus the funds) are normally weighted - so this pressure was going on for some time as the stock got less and less weight. If it is NOT weighted, though, this can put substantial pressure on a dropping stock.
But again, note that funds though passively managed have some leeway - they do not ahve to sell the stock "market" - they can prepare, get and work with options to manage the position better.
