Don't Get Snookered by the Russell Hustle
Less-risky stocks are not necessarily less-risky investments.
Early signs indicate that value stocks in the areas of consumer goods, health care and finance will replace many well-known technology names when some closely followed market averages are restructured on July 1.
The
Russell 2000
likely will say goodbye to stocks such as
Ask Jeeves
(ASKJ)
,
Webvan
(WBVN)
and
buy.com
(BUYX)
and say hello to
AK Steel Holding
(AKS) - Get Report
,
Hercules
(HPC)
and
New York Community Bancorp
(NYCB) - Get Report
.
But analysts say handicapping the annual rebalancing of the major small-cap benchmark -- the Russell 2000 -- and
Frank Russell Co.'s
other 20 market indices is one of the most difficult trades on Wall Street. And it's something individual investors, who may be tempted to invest in companies they believe are going to benefit from the changes, are safe to avoid.
Shuffling the decks of stock market averages is a daunting task, involving thousands of stocks and billions of dollars in market capitalization. Each year, using closing prices on the last trading day in May, the
Russell 3000
collection of the 3,000 publicly traded companies with the largest market caps, gets adjusted. The changes, in turn, affect the Russell 1000 collection of the largest 1,000 companies and the Russell 2000 collection of the smallest two-thirds of the companies.
It takes the Russell folks an entire month to sort out all the names. The first peek into the new compilations comes with the release of the preliminary findings this Friday after the market closes. But that won't be the final word. Two updates follow, each a week apart, before the final list is unveiled at the end of the month.
No Easy Score
At first blush, trying to pick the companies that will score in the Russell 2000 rebalancing seems like a layup. Logic holds that an investor simply needs to go long these companies -- that is to say, bets that over the long haul these stocks will rise -- and short those that are expected to be deleted. Because the Russell 2000 is a benchmark, money managers who run small-cap funds are forced to snap up new companies in order to track -- or try to beat -- the index's performance. But front-running requires a lot of capital and is a default method many pros use during the rebalancing season.
"You want to have a lot of money so you can spread your bets. I mean, you see stories about these stocks that run up 20% or 30%, and then you're like, 'I could have figured that out. I could have bought those stocks early.' But what you don't hear about are all the other stocks that don't run up," said Giri Cherukuri, the head trader at
Oak Brook Investments
, an institutional money management firm based in Chicago with more than $370 million in assets.
There are a lot of mutual funds out there that offer a safer haven for those daring do-it-yourselfers who otherwise would be enticed to play the rebalancing game. There are tons of small-cap funds (including 31 managed by Frank Russell Co.). The current top-performing fund in
Morningstar's
small blend category,
Wasach Core Growth Fund
, is up 25.84% so far this year -- easily topping the
S&P 500's 3.5% stumble. The fund has posted double-digit percentage returns for the last three years. In general, for the year to date, small-cap funds have outperformed their larger counterparts, dotting the top 25 best-performing funds, according to Morningstar. Not one large-cap fund appears on the list.
For the year to date, the Russell 2000 is up about 7%. The
Dow Jones Industrial Average is up about 4% and the
Nasdaq Composite Index is off about 9%.
Investors run into special problems investing in individual small-cap names. Unlike large-cap stocks that have a lot of shares outstanding and a lot of media coverage, small caps often trade no more than six figures in volume a day and usually never make the papers, so they're hard to follow.
Plus, when it comes to playing the rebalancing game, competition is fierce and speculation rampant. Managers have been starting earlier than ever before.
Di Kumble, senior research analyst at
ITG Research
, which has done a lot of research about the Russell, said companies expected to join the Russell 2000 fared 12% better last month compared with the index itself. That's a sure sign many of the stocks expected to be added already have run up.
Timing when to sell and when to buy is the key issue, Kumble said, something that's especially difficult given the volatility in the companies expected to be added. During last year's June 30 trading session -- one day before they were set to become official Russell components -- the additions did pretty well until about 2 p.m. They were up about 4% compared with companies leaving the list. But during the last two hours of the trading day, the stocks being added sold off and underperformed deletions by 8%. That's a 12 percentage-point swing in 120 minutes.
"Sometimes, on the reconstitution day itself, you see spikes in the individual stocks that are masked, just looking at the close-to-close movement. Those spikes represent a very real cost to hedge fund managers and investors in mutual funds," said Ananth Madhavan, ITG's managing director of research. "And all of that is pure subtraction off the bottom line; you're just paying higher prices than other people when you buy the stock and selling at worse prices than other people earlier in the day."
Lined Up for Action
Still, when the preliminary list of the Russell 2000 comes out this Friday, mutual funds that need to own the new companies on the list, as well as investors who are interested in speculating, will be lined up at the open and close to snap up shares. But a lot can change between the release of the preliminary list this week and the issuance of the final list at the end of the month. For one, companies that merge or offer more shares during June may not make the final cut.
And that's not to say that Russell can't make mistakes -- and lead to discrepancies with the initial list -- because data on the number of shares outstanding at small companies can be misleading. Traders such as Oak Brook's Cherukuri say trying to corroborate information is one of the most frustrating things about the Russell rebalancing, involving wading through thousands of
Securities and Exchange Commission
filings.
The bottom line is that managers each year seem to play the Russell rebalancing game earlier, and because media coverage can be intensive. "All these people are trying to play this and as it becomes more and more well known, more and more people will do this and you'll have to do it earlier and earlier," Cherukuri says.
So, the golden goose that many investors have counted on to be out in front -- that stocks in the index outperform those that are deleted from it -- might already have been killed.