The Russell Reconstitution – A different challenge every year
Nov 10, 2003
San Francisco - November 10, 2003. The Russell Reconstitution is undoubtedly the largest annual index rebalance in the U.S. market. Each year, the Russell indexes are reconstituted on the last trading day of June, using price and share data as of the last trading day in May.
The level of interest in the rebalancing activity attracts a multiplicity of investment players, including investment managers, hedge funds, and brokers, who are drawn to perceived performance opportunities. Although Russell reconstitutes its entire suite of indexes, typically speaking, reconstitution for the large-cap Russell 1000 and total market Russell 3000 families presents fewer opportunities than for the small-cap Russell 2000 index. Small-cap stocks exhibit characteristics, such as cost and liquidity, which make them difficult to trade. At the same time, these same characteristics present opportunities to add value for those willing to assume a certain degree of risk. While recent reconstitutions have become increasingly quieter in terms of turnover (see Table 1), all reconstitutions tend to take on different flavors each year. From the Nasdaq outage in 2001 to the microcap rally in 2003, it is clear that no two reconstitutions are ever alike.
|Table 1 - Index Turnover (%)|
||2000 Turnover |
Source: Barclays Global Investors
The backdrop to the 2003 reconstitution reflected the malaise in the broad U.S. economy. However, a key factor in the performance of the Russell 2000 index in this year was the strength of the micro-cap segment of the market. A majority of deletes projected at the beginning of the year came from the biotechnology and software sectors, many of which were arguably priced for bankruptcy. As the market turned upwards following the conclusion of the Iraq war, investors renewed their faith in these small growth-oriented stocks, which were on the cusp of index exclusion. A spectacular rally followed, as the deletes returned 75% from their lows in March.
By contrast, the 2002 reconstitution saw relatively little speculative activity, with most of visible trading occurring around the effective date. The performance of the indexes leading up to the last week of June was relatively muted as Russell 2000 additions only outperformed in the final few days.
The year 2001 was the last reconstitution in recent history where strong add/delete spreads were observed. The reconstitution saw many formerly technology high-fliers crash out of the index altogether or move from the Russell 1000 to Russell 2000 index. On the day of the reconstitution, the Russell 2000 add/delete spread was up 10% after peaking at around 12%. Then on June 29, two primary Nasdaq trading systems went down, considerably disrupting the flow of transactions. This incident caused Nasdaq to extend trading by one hour. The ensuing confusion affected other exchanges; in particular some executions did not reflect the close of that day.
A volatile technology sector made for an interesting Russell event in 2000. This sector troughed in May by over 20% from the start of the quarter, but erased those losses with a strong final three weeks of June. The performance risks associated with such volatility were significant, particularly when coupled with the high turnover seen in this year.
As we have observed from past years, the Russell Reconstitution is a unique event and continues to pose significant challenges for the investment community.
A shorter version of this article will appear in the forthcoming book, Active Index Investing, to be published by John Wiley and Sons in Spring 2004.