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July 5, 2006

Russell Recon: Busy, But Quiet

By Editorial Staff

Fewer changes. Lower turnover. Less volatility. Lower speculative profits. A quiet year is predicted for the Russell Reconstitution and the trading activity surrounding it.

The annual event, in which Frank Russell Company makes changes to its popular indices, is typically the biggest trading event of the year.

Trading started in mid-May this year and may last into July. The official reconstitution date is June 30, a day almost certain to be the largest trading day of the year.

Russell ranks its universe on May 31 and announces the additions, deletions and migrations on June 9. Both those dates are expected to be big trading days, analysts say.

According to Merrill Lynch, about $72 billion in notional value will change hands this year, up from $70 billion in 2005. Merrill estimates that more than half a trillion dollars is in funds that are indexed to the 21 indices of the Frank Russell Company.

Despite the magnitude of the event, making money trading during the Russell period is not a sure thing.

"It's getting harder to extract value from the trade," says John Davi, an analyst in Merrill's derivatives department. "We're not seeing the types of returns we saw four or five years ago."

Merrill is predicting fewer than 500 component changes to the popular Russell 2000 and Russell 1000 indices. That's down from about 600 last year and a recent peak of 1,202 names in 2000.

Fewer changes will lead to lower turnover, according to Merrill, or the value of all trades as a percentage of the value of the indexes.

Merrill predicts turnover in the popular Russell 2000 stocks to come in at 16.6 percent this year, down from 17.6 percent last year and 26.3 percent in 2002.

Much of the decline in the number of constituent changes is due to steps Russell has taken in recent years to mitigate volatility.

Lower volatility makes money managers who must rebalance their portfolios happier.

A key change was Russell's move in 2004 to add initial public offerings to the Russell 2000 on a quarterly basis, rather than once a year.

Volatility has also been dampened in recent years due to increased speculative trading by hedge funds and others.

The stocks in the reconstitution can be broken down into several groups. Four get the most attention however.

The "freshmen," as some label them, or those moving into the Russell for the first time, garner the most trading interest.

Merrill expects about 175 freshmen this year.

The brokerage is also predicting about 160 will fall out of the Russell 2000; another 90 will migrate from the Russell 2000 to the Russell 1000; and about 60 will drop into the Russell 2000 from the Russell 1000.

The Russell 1000 contains the 1,000 biggest stocks, as weighted by market capitalization. The Russell 2000 contains the next 2,000.

Russell Reconstitution-related trading in the freshmen started in mid-May. Trading in the "migrations" between the Russell 1000 and Russell 2000 is expected to kick in during the final two weeks of June.

Indexers typically do the bulk of their trading on the actual effective date, or June 30, requesting capital of their brokers.

All the major program trading houses accommodate the buyside during this event.

Pricing depends on the level of volatility in the stocks on the effective date, traders say.

And this year, the Federal Reserve is expected to meet on June 29th, one trader warns.

Some indexers do trade before and after the effective date, but that can be risky, analysts say.