June is Russll Index Reconstitution Month

The Russell Index Rebalance Arbitrage Play

May 23, 2015 8:11 PM ET|Includes: IWM, IWN, IWO, SPDR S&P 500 Trust ETF (SPY), SRTY, TNA, TWM, TZA, URTY, UW

June's Biggest Announcement - Not From the Fed? By Dr. Van Tharp Trading Institute

Quick quiz: What U.S. equity index family has the most money benchmarked to its indexes?

Standard and Poor's would be a good guess with their popular S&P 500 index -but that's not the one.

How about Dow Jones? Their venerable industrial average is still the most quoted index out there. But that's not it either (and besides, S&P and Dow Jones indexes are both owned by McGraw Hill Financial now…).

And no, it's not NASDAQ.

That leaves us with -drumroll please - the Russell family of indexes.

Russell indexes are benchmarked by $5.2 trillion (yes, trillion with a "t"). According to the folks at Russell, more U.S. institutional equity products are benchmarked against Russell indexes than against all other U.S. equity indexes combined. In market share terms, Russell benchmarks a 73% share of all U.S. institutional equity products.

WOW! There's a fun fact (or three) that I didn't know.

So why the fascination with Russell indexes? Among other reasons, the Russell reconstitutes their indexes each year -unlike the S&P 500 and the DJIA which adjust their indexes on an irregular basis. Russell adds and drops individual companies from their famed Russell 2000 index each year. The same goes for the influential but less widely followed Russell 1000, 3000 and Global indexes.

An Annual Rebalance - So What?

Since Russell has the most widely followed indexes (meaning lots of $$$ involved) and since they have a regular schedule, traders try to game the rebalancing announcement. (I know that Russell uses the term "reconstitute" - but that makes me think I'm messing around with dried mushrooms in an obscure recipe somewhere…)

Here's the essence of the play. The most widely used index for this "reconstitution arbitrage" is the Russell 2000 microcap index. Why? Because usually stocks that are added to this index come from obscurity and go to the big leagues thus requiring index-following funds to buy them also. Stocks that graduate from the Russell 2000 microcap index to the large cap Russell 1000 index don't get the same bump in interest since they are relatively well-known already.

So every year, lots of people try to game Russell's system by guessing which small cap stocks it will add to the Russell 2000 index. The theory is that if you can identify these Russell 2000 stock candidates and buy them ahead of the institutions, you can generate profits after the announcement as the institutions have to buy them.

If you'd like to play the game, consider an important point-one institutional broker forecasts this year's market cap hurdle for any new Russell 2000 member at between $170 million and $175 million. So identifying companies that have grown in market cap since this time last year, have jumped over the hurdle level, have sufficient liquidity and float should give you a decent chance of finding a small cap stock that the Russell folks might be identifying as well.

Such worthy stocks could enjoy the fruits of being added to the Russell 2000 in the coming month. According to the Russell index site, this year's announcement of stocks to be added and dropped will happen on June 12th at 6 p.m. EDT. That list will be updated on June 19th and June 26th. Russell will post the final membership list on June 29th which will give institutions two trading days to make adjustments before the end of Q2.

The Russell Rebalance Arbitrage Play - Some Caveats

Charles Schwab analysts looked at all the stocks added to the Russell 2000 over the last 10 years. They found that those stocks, on average, gained 19.48% for the three month period from March 31 to June 30. Compare that gain to the average Russell 2000 Index gain of 3.03% over the same time period.

As you might imagine, that kind of outperformance has attracted the attention of all manner of institutional traders and investors. So the arbitrage play for these stocks has become crowded. In practical terms, this means that prospective Russell 2000 stock prices move up sooner while the action after the announce date can be precipitous. For example, here's a price chart for OLBK. Amid broad speculation that it would make the cut in 2014, it was indeed added to the Russell 2000.

Look what happened in the months prior to the announcement and then what happened to the price after the announcement:




So if you're tempted to play the Russell 2000 "reconstitution", be aware that the trade has probably gotten very crowded by this point in the process on these thinly traded stocks. Adjust your timeframe for entry and exit and manage your risk accordingly.