IWV - What The Russell Reconstitution Means For Equity Markets

2023-06-10 02:28:00 ET

Summary

• The annual Russell Reconstitution ensures that market changes over the previous year are captured so indices remain representative of the markets they are targeting.
• The reconstitution is one of the most significant drivers of short-term shifts in supply and demand for U.S. equities, often leading to sizable price movements and volatility in individual companies or industry sectors.
• Preliminary results for this year's reconstitution reveal the total market capitalization of the Russell 3000 Index decreased 1.6% and the Russell 2000 Index decreased 10%.

By Payal Shah

Every year, the Russell 1000, 2000 and 3000 indices, considered by many to be barometers of the U.S. economy, take time to look back. The annual Russell Reconstitution, concluding this year on June 23, ensures that changes in market capitalization, sector composition, company rankings and style orientation over the past year are captured so the benchmark indices remain representative of the small and large-cap markets they are targeting.

The rebalance happens, simply put, because markets change and evolve. Successful companies grow, resulting in a rise in their stock price and, consequently, a rise in capitalization. Conversely, other companies are less successful, and their stock price declines.

Annual reconstitution ensures that the Russell Indexes reflect the changes in the U.S. equity markets over the preceding year, in accordance with transparent, public and rules-based methodology. On a predefined schedule, securities are added and removed to and from the index, and the weights among the securities in the index are then adjusted.

Why It Matters

The annual reconstitution is one of the most significant drivers of short-term shifts in supply and demand for U.S. equities, often leading to sizable price movements and volatility in individual company names or industry sectors. The final day of the reconstitution is typically one of the highest trading volume days of the year in U.S. equity markets.

Approximately $12 trillion is benchmarked to these indices through passive investment products like index funds, mutual funds and exchange-traded funds which mirror the composition of the Russell U.S. Indices in their products.

The event can create risks for investors tracking these indices as they need to ensure they have minimal slippage versus their benchmark.

With close to 70% of actively managed institutional U.S. equity assets currently benchmarked to a Russell Index, the rebalance can create opportunities for investors seeking to benefit from the price moves which may be created from the reconstitution. Prior to index reconstitution, investors can use Russell 2000 futures contracts while attempting to benefit from price movements in stocks being added to or deleted from the index. This can help better manage notional discrepancies between the additions and deletions of index constituent stocks.

Trading Around the Reconstitution

Investors with a long position thinking about rebalancing their index exposures may consider buying all index additions and selling all index deletions. Each stock that remains in the index is likely to change its percentage index weight and needs to be replicated by the investor. Operationally, an investor must trade over 2,000 stocks in the exact quantity for each individual name.

The same applies for short positions, with the added complication that an investor must locate a source to borrow the relevant shares to short each individual name that remains within the index, often in less liquid names. In either case, the adjustment is susceptible to operational error, which may lead to index tracking error.

CME Group E-mini Russell 2000 Index Futures ( RTY ) may be a useful tool for managing additions and deletions. The benefit of holding a futures position is that the investor does not have to trade the reconstitution themselves; the futures contract will track the index and there will be no tracking error incurred by trying to replicate the reconstitution.

On the reconstitution day, The Basis Trade at Index Close (BTIC) mechanism permits RTY contracts to be traded at a spread to the day’s official index closing value and serves as an alternative to trading many cash baskets. It minimizes transaction costs and is a more efficient route to achieving the desired equity exposure.

An Exchange for Physical (EFP) transaction allows an investor to exchange shares for an equivalently scaled number of RTY contracts, and then to carry the resultant futures position through the index rebalancing.

Some investors may carry mandates that allow discretion, prior to index reconstitution, as to the composition of the cash index baskets that may be used for equitizing fund cash flows. The investor can use RTY contracts as part of the core portfolio holdings to better manage notional discrepancies between the additions and deletions of index constituent stocks.

What Does Early Reconstitution Analysis Tell Us?

Preliminary results for this year’s reconstitution reveal the U.S. broad market decreased modestly in size, with the total market capitalization of the Russell 3000 Index down 1.6% from $44.9 trillion as of last year’s rebalance to $44.2 trillion based on this year’s rank day of April 28. The total market capitalization of the Russell 2000 Index decreased 10% from $3 trillion as of the 2022 reconstitution to $2.7 trillion in 2023.

Comparison of year-to-year changes in the market capitalization breakpoint, which separates between large-cap and small-cap sectors, makes a useful gauge of secular growth in market valuations. This year, the breakpoints separating small caps (Russell 2000 Index) and large caps (Russell 1000 Index) decreased by 8.7% to $4.2 billion, following a volatile year in U.S. equity markets, where small-cap stocks underperformed large-cap stocks.

Banding minimizes unnecessary turnover: any incumbent index member will get moved from the large-cap segment to the small-cap segment, or vice versa, only if its newly evaluated market cap falls outside a 5% band centered around the breakpoint.

The largest company in the Russell 2000 is valued at $6 billion (Intra-Cellular Therapies ( ITCI )) and the smallest company at $159.5 million (Protalix BioTherapeutics ( PLX )). Following are a few other key points around the newly reconstituted index:

• A total of 297 companies will be joining the Russell 2000 Index, with 25 dropping down from the Russell 1000 Index / Russell Midcap Index, and 192 shifting up from the Russell Microcap Index.
• Three IPOs are being added: two from Industrials and one from the Energy industry, while 73 companies are joining from outside the Russell U.S. Indexes universe.
• 192 companies are departing the index. 24 companies are moving to the Russell 1000 Index (in particular, Health Care, Consumer Discretionary, and Financials industries), 83 are moving to the Russell Microcap Index, and another 85 companies are leaving the Russell U.S. Indexes universe altogether.
• The largest industry in the Russell 2000 remains Industrials at 17.7%. This is closely followed by Health Care at 17.4% and Financials at 14.2%.

The annual reconstitution requires thoughtful and well-executed risk management on the part of investors. It is one of the most significant drivers of short-term shifts in supply and demand for U.S. equities, often leading to sizable price movements and volatility in individual companies or industry sectors.

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Editor's Note: The summary bullets for this article were chosen by Seeking Alpha editors.

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