Russell 2000 Getting Set for a Wild, Woolly Rebalancing

It's been a rocky year for the Russell 2000 index. Up 20% through the beginning of March, down about 15% since then, the small-cap benchmark is in the midst of its most volatile year ever. And with its annual rebalancing fast approaching, it doesn't look like it's going to get any smoother.

The Russell 2000 is ostensibly the bottom 2,000 of the 3,000 largest U.S. stocks. In practice, that is never quite true. Some stock has always outperformed and gotten, really, far too big for the index. Some other stock is far too small. But it would be nearly impossible to constantly update the index so that it really reflected what it's supposed to. And even if it were possible, funds that track the index couldn't keep up with the changes.

Sensibly, Frank Russell Co. changes the index only once a year, taking a snapshot of the market on the last trading day in May and reconstituting the index on the first trading day in July (July 3 this year). A preliminary list of the reconstituted index will come out Friday, with follow-ups June 16 and 23.

Even with a long preparation period, the rebalancing is tremendously disruptive. Stocks added to the Russell jump as indexers buy them while stocks dropping out fall. Usually there are investors who seek to profit from this, going long additions to the index, shorting deletions. And some fund managers who closely track the Russell may try to front-run the changes, trying to grab some extra basis points in performance vs. the benchmark.

But with the way stocks have been jumping around this year, trying to game the Russell reconstitution could be incredibly dangerous.

"Volatility has been twice as high as the historical average," notes Steve Kim, equity derivatives analyst at Merrill Lynch. "There's definitely more risk in this than we've seen in previous years." It does not help that the market is unclear about what the Federal Open Market Committee will do with rates when it meets June 27 and 28.

Poor Performance Among Entering Stocks

Moreover, the stocks that look like they'll be added to the Russell 2000 have not been performing very well, particularly the many dot-coms that will be added to the index -- a factor that may drive away investors who otherwise would jump the gun on the annual rejiggering.

To take one example, e-business software company Breakaway Solutions (BWAY Quote), which went public in October, finished its first day of trading at 21 1/8 and zoomed as high as 85 1/2 intraday March 7 (adjusted for a 2-for-1 split). From that peak, the stock plunged 65% through Friday's close of 29 7/8, but its market cap of $873 million as of Wednesday was easily good enough to put it on the Russell 2000 entry list (stocks with May 31 market caps between about $197 million and $1.568 billion are eligible).

"The most amazing statistic to me is that the Internet stocks coming into the Russell are down 61% year to date," says Howard Penney, a principal at Morgan Stanley Dean Witter. "They've just gotten decimated."

It's part of an unusual trend of the current Russell stocks outperforming the stocks that analysts reckon will be included in the index after the rebalancing. This reversal is probably because so many of the new additions to the index went public just in the past year. For the Russell 3000, which includes the Russell 2000 and the large-cap Russell 1000, "we're estimating 45% of the new additions will be new IPOs," says Tomas Bok, manager of the structured trading strategies group at ITG. "It was 33% in 1999." As a result, performance isn't as much of a factor as in other years for inclusion in the revamped index.

With investors wary of playing early, the action could get hot and heavy in the days just before and just after the rebalancing. Heightening the effect, many of the companies getting added this year have very small floats, with most of their outstanding shares not on the public market.

"These are very illiquid stocks and very difficult stocks to execute trades on," says Kim. As a result, they could see some pretty huge moves higher when rebalancing day rolls around.