There's a rumble coming in the

Russell 2000

small-cap stock index and it might leave small-cap fund managers and their shareholders with a taxing headache.

On Friday night investment management consultant

Frank Russell Co.

released a preliminary list (see Russell's

Web site ) of the stocks entering and leaving the

Russell 3000

, an index of the 3000 largest U.S. stocks ranked by market capitalization. As the Tacoma, Wash.-based firm prepares for the annual June 30 rebalancing of its 21 stock indices, most eyes are focused on the small fry, a.k.a. the Russell 2000, which is essentially an index of the 2000 smallest stocks in the Russell 3000.

Why? Experts

say a host of tech-stock graduations from the sub-$1.5 billion market-cap arena that typically defines small-cap and the addition of recent initial public offerings to the index will make this year's turnover higher than usual. This year more than 520 new names are expected to end up in the index, which adds up to 33% turnover, compared with 27% last year. Since the benchmark is the model for most small-cap index funds and the yardstick for most actively managed small-cap funds, a big shift could leave fund managers with tough decisions and stick their shareholders with taxable capital gains distributions.

In addition to the taxing matter, investors smitten by smallness face another issue. After the rebalancing, the Russell is going to have a new personality, one that is less tech-oriented and more Old Economy.

There are some 20 retail index funds that track the Russell 2000, according to Morningstar, and if you own one, your manager is a little preoccupied these days. To mirror the index's performance, he or she has to buy and sell stocks to reflect the rebalancing. That means dumping bigger stocks that leave, such as $12.9 billion


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, and putting that cash to work in smaller, more thinly traded stocks that are entering the index. The challenge: rejiggering the portfolio without locking in hefty cap gains.

It's this annual tune-up that makes large-cap index funds, which don't have a graduation dilemma, generally more tax-efficient than small-cap index funds.


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500 Index fund, for instance, which tracks the S&P 500, sports just 6% turnover, according to Morningstar. On the other hand, the index behemoth's

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Small Cap Indexfund, pegged to the Russell 2000, has a 42% turnover ratio.


rebalancing is one of the downsides of indexing in the small-cap area," says William Harding, the Morningstar analyst who covers $3.9 billion

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Vanguard Small-Cap Index, the largest retail Russell 2000 fund.

Vanguard has tried to address the problem with its

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Tax-Managed Small-Cap fund, started last March. The fund focuses on low-dividend stocks in the

S&P 600

, a small-cap index with lower turnover. It's too early to judge its tax advantages.

For funds pegged to the Russell, adding the new names isn't necessarily as tough as it sounds because most will have small weightings and many index funds don't own every single stock in the index, in order to keep expenses down, says Morningstar's Harding. Still, selling some of the graduating biggies will trigger capital gains. A manager can try to offset those gains by selling losers along the way, but that's not easy.

"These rebalancings can be costly. You need to be vigilant about getting through these things as efficiently as possible," says Vanguard spokesman Brian Mattes. Gus Sauter, Vanguard's index-fund guru, is the consensus king of index-fund managers. And even his Small Cap index portfolio has just middling tax-efficiency ratings from Morningstar over the past three- and five-year periods compared with other small-cap blend funds.

Of course, index funds aren't the only portfolios affected. The rebalancing could have repercussions for actively managed small-cap funds because many use the Russell 2000 or its Value or Growth version as a benchmark.

"No small-cap manager, index or active, can afford to live in ignorance of the index, because that's their benchmark and they're judged against it," says Anurag Pandit, co-manager of


John Hancock Small-Cap Growth.

Active managers might not be required to buy new additions and sell emigrating stocks, but many might be concerned by the index's new personality after rebalancing.

"It's going to be a very different index after the rebalancing. It will be more Old Economy than New Economy," says Steve Kim, an equity derivatives analyst at Merrill Lynch. Beyond a big uptick in the number of new faces, Kim anticipates the index's tech weighting to drop to 13.1% from 21.1%.

The average small-cap blend fund has been overweighting tech stocks, according to Morningstar, so many managers' modest bets will look a lot bigger after the rebalancing. Consequently, many active small-cap managers might scramble to keep their sector overweightings under control.

All this scrambling among passive and active fund managers could make for even more volatility among the small-cap crowd in the two weeks before and after the rebalancing, Merrill's Kim says. Although no small-cap managers will tip their hands, many believe they've already started the rebalancing process -- particularly those running index funds.

"I'm sure they're all doing it now. Index managers are probably trying to make some moves early. I'm sure the Gus Sauters of the world have already made the calculations and they've been making moves," says Jeff Troutner, president of

TAM Asset Management

in San Anselmo, Calif., and senior editor of He advises investors to buy small-cap index funds in tax-deferred accounts to eliminate tax headaches.

Whether you eliminate your tax worries or not, the upshot for all small-cap fund investors is that they might be in for a rough ride over the next few weeks -- and maybe a nasty tax bill in April.