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.
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
Sellside program trading desks usually offer indexers guaranteed price deals for the reconstitution. Depending on where the risks lie with each rebalance, some guarantee prices better than the closing print or offer "profit-sharing" program trades. How aggressive the sellside is depends on factors that change every year. Most reconstitution-related trading among index funds occurs on the reconstitution day and in the weeks leading up to the event. The largest indexers can execute 25,000-40,000 trades on reconstitution day. A recent development that has improved the small-cap portion of the Russell rebalance is Nasdaq's closing cross, an electronic auction launched in April 2004. On last year's reconstitution day, the Nasdaq cross – which had been in full force for less than two months – executed 333 million shares, totaling $5.3 billion. The closing cross did away with the uncertainty that plagued institutional investors trying to get the closing print. The new closing cross is a sign of how far Russell has come since 2001. On June 29 of that year, the day of the annual Russell reconstitution, a Worldcom employee ran what he thought was a test on Nasdaq's automated quote system, which Worldcom managed. The mistake brought down the Nasdaq market in mid-afternoon, halting all trading. Nasdaq was forced to reopen from 4 p.m. to 5 p.m. for an unprecedented after-hours session. "We've gained the attention of more market players over the years," says Kelly Haughton, strategic director of the Russell indexes. "Nasdaq has put into place effective safeguards against this happening again."
