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June 20, 2005

Managing the Russell Recon: A Decade of Change for Traders

By Nina Mehta

There are a few reasons for this. Russell Investment Group has gradually made a number of improvements related to the reconstitution. Buyside trading desks also have more technology, direct market access, and analytical tools at hand. Most important, however, is that there are more players of all stripes - from index funds to actively managed funds, proprietary trading desks and hedge funds - participating in reconstitution-related trading.

Benchmarked assets have risen as more eyes focused on the Russell rebalance as a trading event. That focus eliminated many of the pricing inefficiencies that hurt institutional investors in years past. By the end of 2004, $480 billion was passively indexed to Russell benchmarks, up from $426 billion the previous year. That's four times its passive assets of five years ago.

At year-end Russell had a total of $2.5 trillion in passive and active funds benchmarked to its indexes. It had less than $600 billion in 1999. The increase in assets makes the reconstitution trade "much more significant," despite the lower turnover, says BGI's Frost.

'It is dangerous to extrapolate from the last reconstitution.'

Corin Frost, BGI

Aggressive Arbitragers As index assets grew, statistical arbitrage and index arbitrage hedge funds have become more aggressive about taking the other side of indexers' trades. "They trade these events and facilitate back into the market the flows that are required for index funds," says Phil Mackintosh, an analyst in the quantitative equity derivatives group at Credit Suisse First Boston. Indexers and money managers base their reconstitution strategies on market conditions and order flow information as the reconstitution approaches. They must also gauge how much trading activity has already taken place. Barclays Global Investors analyzes and deconstructs a variety of factors before determining a trading strategy. These include the liquidity and risk characteristics of individual stocks. Other factors used are changing, historical and event-specific trading patterns, and options volatility. Passive indexers as well as enhanced and active money managers begin studying the Russell rebalance in January. They get reams of research from Wall Street and other sellside brokers. Most also do their own extensive analyses. BGI has three in-house index analysts. Other large managers of Russell index funds go through the same process. As June approaches, "we adapt our strategy to what's going on in the marketplace-what we hear is happening from brokers, how much capital they might make available, and what's going on in the hedge fund community," says Alex Matturri, director of Global Equity Index Management at Northern Trust. The asset management firm has $200 billion in indexed and quantitative funds. Fund managers then figure out which brokers to trade with and how much risk they are willing to take on. Another critical aspect to managing the reconstitution is integrating index-related trading with customer cash inflows and outflows. The bulk of reconstitution-related trading takes place through program trades. Program trading is an efficient and cheap way for institutional investors to execute large trades with minimal market impact. Indexers have always used program trades, but active managers increasingly rely on them. Nearly every order management system now can execute program trades. A decade ago, that wasn't the case.

'It's a pretty smooth event. It's not that exciting anymore.'

Martha Ortiz, Aronson+Johnson+Ortiz