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June 1, 2012

Could Volcker Affect the Rebalance?

By James Armstrong

Russell Investments will rebalance its indexes this month, and the industry is wondering if this year will see sufficient liquidity for the rebalance, or if the impending Volcker rule will mean less flow coming from proprietary trading desks.

In the last two years, the Russell rebalance has been relatively orderly, as buys and sells were able to pair off without much market dislocation-at least when compared with rebalances during the financial crisis.

Phil Mackintosh

But this year's June 22 rebalance could be affected by the Volcker rule's requirement that banks divest themselves of their prop desks, said Phil Mackintosh, global head of trading strategy for Credit Suisse. He wonders whether imbalances will continue to shrink as in recent years.

"If all other things were equal, I would say this year would probably continue that trend, and the trade would get closer to being matched, but I think Volcker is the elephant in the room," Mackintosh said.

Although the Volcker rule, which bars banks from engaging in proprietary trading, has been postponed, many banks are already shedding their prop desks, which could impact liquidity.

Each year, the rebalance requires huge amounts of liquidity toward the end of June, when Russell posts final membership lists for its indexes. For the reconstitution of the indexes to run smoothly, some traders-usually from prop desks, hedge funds and mutual funds-take speculative positions they will later offload to index funds.

The speculators buy up an inventory of new names to sell to index funds and short the dropped names to buy them back on the day of the rebalance. Since Russell starts releasing information at the end of May, the speculators have plenty of time before the rebalance at the end of June, when most index fund managers wait until the last few minutes of rebalance day to make their trades.

In 2006 and 2007, speculators went overboard causing a "wrong way" rebalance in which they overbought the stocks added to the indexes and had too many shorts on the stocks being left off. The credit crisis changed all that, and in 2008 and particularly 2009, the speculative community largely avoided the Russell rebalance, leading to a "right way" rebalance; index funds struggled to get enough liquidity in the names they needed to change.

Though some rule changes still kept speculators away in 2010, last year saw a more typical rebalance, in which there was a fair amount of liquidity available for index funds. The question now is whether speculators will be able to match the rebalance with the inventories they have built up in the months ahead of the reconstitution.

While many banks seem to have already purged their prop trading businesses, it is still unclear where all those prop traders have gone.

"We don't know if they've started up hedge funds," said Mackintosh. "We don't know if the hedge funds have the same capacity and risk appetite as the prop desks used to have, same access to borrow as they used to have."

Charles Behette, a director at ITG and the firm's resident index expert, said this year's reconstitution will likely be orderly like last year. He said traditional asset management firms could pick up some of the slack left by prop desks.

"There are a lot of mutual fund managers being compared to ETFs, and they're looking to enhance their returns this year to differentiate themselves," Behette said.

Russell releases preliminary lists of the stocks in its 2012 indexes on June 8.

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