Want to try and frontrun an index rebalancing? There’s a formula for that.
The Russell 3000 — to which more than $5 trillion in assets were benchmarked as of 2013 — will be reconstituted next month based on market capitalizations calculated at the end of trading today. Here’s the schedule:
Clearly, correctly anticipating which names will ultimately be added or dropped has the potential to produce outsized gains as portfolio managers will need to rebalance to match the composition of the index. It’s possible to attempt this ahead of time using Russell’s own methodology and indeed, Wall Street employs strategists whose job it is to do just that.
H.C. Wainwright has attempted the exercise, and for those interested, the results are below.
Given the size of the exchanging pie, the attraction of properly anticipating the changes associated with the potential for lucrative trading gains captivates bulge-bracket firms, independent research houses, and money managers alike in postulating on how the cards might fall on that last business day in May when Russell reconstitution market capitalizations are calculated.
The dynamics are not missed by the academic community either, and the index reshuffling process has attracted the attention of various financial scholars in attempt to map the effectiveness of gaming the index changes. With this paper, we attempt to offer a snapshot of the task required and the scope of inherent difficulties in forecasting changes in the Russell universe while offering a stab at the process ourselves. As a backdrop and according to people we talked with, there are in the range of 20 to 30 people in the global FTSE-Russell research and production group that sift through available public information in determining constituent index members. Other firms that have tackled the exercise, such as Deutsche Bank, have certified strategists and statistics experts embedded in highly qualified teams of research people in effort to predict the Russell transformation. Furthermore, there are independent research firms that have made ‘playing with Russell’ a core competency, and New York-based Investment Technology Group serves as an example of a company’s focused quantitative index study in addition to the host of other strategic analytic work that particular firm conducts…
Methodology of the reconstitution itself.
No, we’re not referring to the illustrious document that framed our nation, but instead the process Russell follows to create the backbone of the index. This discussion is interesting from a number of perspectives: (a) gaining an understanding of the general process as outlined by Russell’s Construction and Methodology document (the company’s effort to provide transparency to the construction process); (b) offering a backdrop for the discussion of introduced errors in mimicking Russell’s process; and (c) acquiring an appreciation for the nuances and complexity involved in the process despite the transparency and predictability Russell claims is evident.
Yes, the process is clearly explained in Russell’s documentation, but the execution is not nearly as easily followed as one might first think, in our experience.
Essentially, the investment bank has used market capitalizations from May 20 and the following algorithm in an effort to predict additions and deletions…
Here are the results...