The Looming Russell Rebalance – What You Need To Know

Via ConvergEx's Nichaolas Colas,

How many stocks are in the small cap Russell 2000 index?  Nope, not 2,000… The answer is currently 1,987.  The Russell 1000 (large caps) has 1,036 names, and the Russell 3000 (essentially the whole U.S. market) has 3,023.  Yes, the world of indexing is complex.  Another more practical and immediate example: every May/June, Russell goes through the process of rebalancing their indices, and we are quickly coming up to an important series of deadlines in that workflow.


Today, with a lot of help from the Convergex Portfolio Trading group, we summarize what this all means.


Two key takeaways. One, Health Care sees the largest changes of any sector with many names moving from the 2000 to the 1000.  Two, several hundred individual names stand to move into/out of the Russell 2000 across all industry groups. Also, June 2015 will almost certainly be more volatile than June 2014, when the average CBOE VIX Index was just 11.5.  With over $4 trillion invested in Russell index-linked products, this year’s rebalance combined with the “Will they/won’t they” Fed rate increase debate could make for an eventful start to summer.

Investing may be an old concept, dating back through the millennia, but the notion of measuring asset price performance through the lens of an index goes back less than 120 years. The oldest such measurement that market participants still use today is actually not even an index at all. It is the Dow Jones Industrial Average, which is price weighted.  That’s because Charles Dow’s solution for aggregating and explaining the market action of various stocks was to add up their prices into one measure. A $100 stock has more influence than a $10 one. And that’s exactly how the Dow has been calculated since 1896.
Fast forward to March 4th 1957 and Standard & Poor’s launches a true “Index” of 500 large capitalization U.S. stocks. 
The firm used the now-common approach of market capitalization weighting, giving more influence in the new “S&P 500” to the largest companies in a given industry or relative to the market overall. Then in 1984 Frank Russell started the Russell 1000, 2000, and 3000 benchmarks to evaluate manager performance for the firm’s advisory practice. The three indexes track Large Caps, Small Caps, and the entire U.S. market (about 98% of it, to be precise), respectively.
Between the Russell 1000, 2000, and 3000, there is approximately $4.4 trillion of investor capital tracking these benchmarks and their offshoots. And, unlike many other index providers, Russell (now owned by the London Stock Exchange Group) resets their indices just once a year. In the case of the Russell 2000, for example, there is some $952 billion invested in this small cap index and its Growth and Value variants. And every year all of it gets rejiggered as Russell reevaluates which stocks should be in the 1000 (Large Cap) and 2000 (Small Cap) benchmarks.
So…  A trillion dollars of gross capital moving through a wide range of U.S. small cap stocks. What could go wrong? The short answer is that nothing much tends to go awry, because Russell is very transparent throughout the reweighting/reconstitution process. By the time comes for all the capital dedicated to these indices to move with the annual changes, there are very few surprises.
That doesn’t make the “Russell Rebalance” – the nicely alliterative label for these index changes – easy to understand for those unfamiliar with the intricacies of indexing (we can alliterate with the best of them). Today we’ll lean on the expertise of our Program Trading desk, which has done the heavy lifting here. The bottom line is that the Russell Rebalance is sufficiently all encompassing that it touches +95% of the entire U.S. stock market by capitalization. That means that any equity you own – or are thinking of buying or selling – is very likely touched by the upcoming rebalance.
Now that I have your attention, here are the particulars:

#1: When does all this happen?  Since effectively communicating the changes to the indices limits the volatility on the actual date of the reconstitution, Russell is very transparent about its evaluation process. The key dates this year are as follows, with descriptions from Russell regarding what happens when:

  • May 29. “May is ‘ranking’ month when the largest global companies are lined up to form the preliminary reconstitution portfolios. In 2015, the last business day falls on Friday, May 29.”  Keep in mind that the Russell indices include/exclude names primarily on a market capitalization basis with some basic liquidity and float requirements layered on top.  If the 3000th name by market cap in the U.S. equity market has a capitalization of $173 million, then any company with a lower market cap will not make it in.
  •  June 12th.  “Preliminary lists are communicated to the market place.”
  •  June 19 & 26.  Updates to the lists are provided.
  •  June 26th.  “Newly reconstituted indexes take effect after the close.”

 In case you don’t have a calendar in front of you, there are 2 days after the Russell Rebalance before we close the books on Q2 2015.  That’s a positive for both the rebalance process and markets as a whole, since the volumes related to the rebalance will not come on the last day of a quarter.


#2: Is there anything new about the reconstitution process this year?  The short answer is “Yes”. Companies with multiple share classes (think Google, with its GOOG and GOOGL symbols) where the securities individually meet the criteria for index inclusion have the chance to get both stocks into the relevant Russell index. This is not something unique to the Russell indices, by the way. Fun fact: there are 503 stocks in the S&P 500 because of the same process as Russell is using here. Google’s two classes of stock have an aggregate 1.64% weight in the 500, broken up into GOOG (0.81%) and GOOGL (0.81%).


#3: What are the large scale impacts of the 2015 Russell Rebalance? Courtesy of the Convergex Program Trading Desk, a few points:

  • Any U.S. company with a market cap of $173.3 million or higher should be in the Russell 2000 if they meet the liquidity and float requirements. For the Russell 1000 Large Cap index, that number is an estimated $3.3 billion. For example, if a company went from a $100 million market last year to $200 million this year, it should be added to the Russell 2000 as long as it trades more than the average global stock and has +5% of its shares available to trade.
  •  We expect 212 companies to be deleted from the Russell 2000 this year for falling below the market cap cutoff, and 102 to be added.  For the Russell 1000, we expect those counts to be 9 added, 3 deleted, and 40 to move from the Russell 2000 to the 1000 because their market caps have increased.
  • Given that Health Care stocks have done very well over the past year, it should be no surprise that this group sees the most names migrating from the Russell 2000 (small caps) to the Russell 1000 (large caps).  But that also means that the aggregate weighting of Health Care in the Russell 2000 will decline, from 15.6% to 14.3%.  Financial Services will pick up some of the slack in the 2000, going from 24.9% to 25.4%.

 #4: How do I make money from this trade?  The most common strategy is to try to predict what stocks will make their debut appearance in the Russell 2000.  Since that’s not especially hard to figure out once you have a sense of the market cap cutoff (that $173.3 million number we referenced), it is safe to say that a lot of traders have the same idea. For those of you curious to see the list of these names on the cusp of Russell index inclusion just ping me and we’ll put you in touch with our Program Trading team.


#5: How do I not lose money from this trade?  This is the more important question, for imbedded in these lists of potential Russell adds, changes and deletes are hundreds of equities that you may see as a potential investment, or something you own that you may want to sell. In these cases, trading the name during June becomes distinctly more challenging. After all, there will be plenty of traders trying to work out how much Russell-linked funds they will have to buy or sell on June 26th.

The analogy that comes to mind is walking into a bar and discovering it is karaoke night, and everyone has to sing. You think you are just going out for a quick beer, but unbeknownst to you the Russell Rebalance means you’re soon on a stage with a mic in your hand.  And maybe it’s OK, because the song is “Born to be Wild”.  Or maybe it’s “Total Eclipse of the Heart”. And that’s not OK.  As an institutional investor or trader, you need to know which it is going to be. And that means having the Russell add/delete/change list close at hand in June.
The bottom line is that the Russell Rebalance is, in many ways, the biggest trade of the year. Lots of capital tracks these indices, and much of it centers on smaller capitalization names. The information is all there to assess the annual Reconstitution’s effect on individual securities, so there’s no excuse for not knowing.