Today will almost certainly be the busiest trading day of the year, as the Russell indexes go through their annual rebalancing/reconstitution. But, as ConvergEx's Nick Colas notes, Friday’s close will be the end of a trade that began almost 2 months ago, as traders began handicapping which equities would be included for the first time or swapped between various Russell indices. Since the beginning of May, for example, the stocks that will be added to the Russell 2000 are up 11%, and those being deleted from the same index are down 2% over the same time period.
Today’s trading will likely see those trends continue, with as much as half the total day’s volume concentrated in the last 5 minutes of the day. Also look for names swapping between the widely followed Russell 2000 and the less-commonly tracked Russell 1000 to have some one-day volatility. In short, for one day – and this is the day - every U.S. equity market participant, no matter what their investment mandate, needs to think like a trader.
Throw in a little Greek drama going into the weekend, and it could be quite a day…
Groucho Marx had many memorable witticisms in his decades-long show business career, but my favorite is a handwritten note to an exclusive Hollywood watering hole: “Please accept my resignation. I don’t want to belong to any club that will accept people like me as a member.” The venue in question was the Friars Club of Beverly Hill, where everyone from Judy Garland to Dean Martin, Jerry Lewis and Johnny Carson belonged and (seemingly) had no problem with the place. Groucho, however, had joined the club under some pressure from his Hollywood friends. He never went, and when he finally decided to drop out the club president wrote to ask why. His response went out, the story made the rounds, and eventually the whole affair ended up being published first in the New York Herald Tribune and then Readers Digest. At least that is the most commonly cited story of this now-famous reverse-rejection letter…
In capital markets, of course, you never turn down a club membership and you certainly never decide to leave once you achieve admittance. The “Clubs” here are indexes (indices, if you had any Latin in high school and want to stand on formality). And just like social clubs, the older ones tend to be pickier. The Dow Jones Industrial Average dates back to 1896, and like grand old New York clubs of similar vintage only accepts a handful of members every decade. The S&P 500 is of a later age – the 1950s – and is slightly more accommodating by virtue of a 500 company membership roll rather than only 30. And then there is the Russell complex, founded in the 1970s, which does its best to be inclusive in the modern sense of the word: the large cap Russell index has 1000 names and the small cap version has 2000. Between the two, you get something north of 90% of all reasonably investable American stocks.
Today is essentially membership day for the Russell indices, with the close representing the start of a new club season, so to speak. The process actually began back in May, with Russell measuring every U.S. public company on metrics such as market capitalization, trading liquidity, and available float. Unlike most private clubs, every company has to essentially reapply every year; drop below certain minimums – especially market cap – and you get the boot. Back on June 12 and then again on the 19th, Russell published lists of which companies would be in the Russell 1000 (large caps) and Russell 2000 (small caps), among several other indices.
The stakes are higher than just bragging rights at the office, for there is over $4 trillion of capital benchmarked to the Russell indices. Being “In” means a larger base of passive investors to own your stock and also active managers who have to consider buying shares. Being kicked out means losing almost all those owners, and largely in one day. That day is today. And that’s why the folks at Russell publish the final lists a week before the actual rebalance day – to give markets a week to adjust prices for securities that are either being added or deleted from the indices, or moving from the Russell 1000 to 2000 or vice versa.
In truth, however, markets and traders have been handicapping likely Russell adds, deletes and moves for over a month. How do we know? The Convergex Program Trading desk put together an analysis of how the various stocks that are transiting into/out of/in between Russell 1000 and 2000 indices. Here’s the math:
The 120+ names being added to the Russell 2000 are up an average of 11% since May 1st. This didn’t happen all at once, nor did it even happen in June when the preliminary names were announced. No – this group advanced 10% in May, and was up as much as 15% on June 15th. And the final move – today – could take this select list higher still.
In contrast, the handful (19, by our calc) of companies entering the Russell 1000 are up a mere 29 basis points since May 1st.
Even though most market participants are more familiar with the Russell 2000 as a de facto standard for small cap indices than the Russell 1000 for large caps, companies moving from the 2000 to the 1000 today are up 6.2% since May 1st. This may seem odd because common wisdom has it that far more capital is benchmarked to the 2000 than the 1000, resulting in a net sale position for equities making that transition.
Another seeming anomaly – the 50 companies moving from the 1000 to the 2000 are down 3.2% since May 1st. Again, the common perception is that moving “Down” to the 2000 means actually picking “up” more potential capital.
And how about those companies that are getting the heave-ho entirely? Yep – not good news there. The average return for the 150+ companies leaving the Russell 2000 is -1.9% from May 1st to today.
There is, of course, one remaining question: how close have the traders who are essentially renting these positions until the “Real” owners show up today gotten to accurately pricing the supply/demand imbalances created by the adds/deletes/moves? Will the Russell 2000 “Add” names trade higher today on the back of strong demand from index-oriented investors? Will the equities moving from the Russell 1000 to the 2000 see the benefit of strong demand going into the closing bell from their new, more widely followed index?
It is for this reason that Russell rebalance day is often the busiest single trading day of the year. Our head trader, Pete Coleman, told me that he expected this to be the case today. That’s how important the Russell rebalance can be. And it tells me one thing. Everyone is essentially a trader today, regardless of what your investment mandate is every other day of the year.
Ignore that advice and you might end up (figuratively) quoting another famous Groucho Marx line. In response to an ill-mannered heckler, he said “Drop dead? Why, that’s the last thing I’ll do”...