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June 20, 2005

Managing the Russell Recon: A Decade of Change for Traders

By Nina Mehta

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  • Managing the Russell Recon: A Decade of Change for Traders

Back in the Internet craze of the late 1990's, the annual reconstitution of the Russell indexes was a traumatic ordeal. A third of the Russell 2000 small-cap index typically changed each year. As a result, index fund managers had to scramble every June to realign their portfolios.

Seven or eight years ago, the reconstitution was viewed "largely as an opportunity for dealers to make a lot of money," says Doug Rivelli, director of program trading at institutional broker Weeden & Company. He adds that "indexers on the buyside traded with program desks and were happy to accept a deal that was better than the closing price because that meant they would outperform their benchmark."

But since the tech craze, the Russell reconstitution has gotten a lot saner. Turnover in the Russell 2000 this June is expected to be 15 percent of the index's total market capitalization, down from 17 percent last year.

"It's a pretty smooth event. It's not that exciting anymore," says Martha Ortiz, a portfolio manager at Aronson+Johnson+Ortiz. AJO is an investment manager with $20 billion under management. About 80 percent of that is indexed to various Russell benchmarks.

Low Turnover

Turnover in the large-cap Russell 1000 is expected to be less than 2 percent, versus last year's 3 percent. Small-cap indexes see more change than large-cap and broad-market gauges because their constituent stocks are smaller and more volatile.

The Russell reconstitution is one of the largest annual trading events. Every year, at the end of May, Russell ranks the 3,000 largest U.S. companies by market capitalization. The top 3,000 stocks end up in the broad-market Russell 3000 index. That index represents 98 percent of the total market capitalization of U.S. stocks.

The stocks are simultaneously slotted into various sub-indexes. These include the large-cap Russell 1000 (the top 1,000 stocks in the Russell 3000), the small-cap Russell 2000 (the next 2,000 stocks), the value and growth indexes within those two indexes, various blended style indexes, the Russell 2500, and so on.

Russell's 22 market-cap-weighted indexes are "reconstituted" on the last Friday in June, based on that day's closing price for stocks. This year's reconstitution takes place on June 24.

Every year buyside fund managers re-work their Russell rebalance strategy. "It is dangerous to extrapolate from the last reconstitution and frame your trading strategy around that," says Corin Frost, a senior portfolio manager at Barclays Global Investors. BGI, the largest index fund manager in the Russell universe, manages $1.3 trillion, including about $100 billion indexed to Russell benchmarks.

In addition to its index funds, BGI manages iShares, a string of popular exchange-traded funds. BGI takes the same trading approach to index changes in its Russell-based ETFs and to its passive funds with the same benchmarks.

In 2003 and 2004 the Russell reconstitution "became more efficient and the index industry was able to rebalance their portfolios more intelligently," says Jian Yang, co-head of financial engineering at brokerage firm ITG Inc.