Why Index Reconstitution?
The U.S. equity market is the largest publicly traded securities market in the world. The rebalance happens, simply put, because markets change and evolve. The annual reconstitution ensures that the Russell U.S. Indexes are recast to reflect changes in the U.S. equity markets over the preceding year in accordance with the transparent, public, rules-based methodology.
During the multiweek rebalancing process – concluding this year on June 25 – changes in market capitalization, sector composition, company rankings and style orientation are captured to be reflected in the new index composition and allow the different indices to remain representative of the benchmarks they are targeting.
Why Is This Important For Investors?
The annual reconstitution is one of the most significant drivers of short-term shifts in supply and demand for U.S. equities, often leading to sizable price movements and volatility in individual company names or industry sectors. The final day of the reconstitution has typically been one of the highest trading volume days of the year in U.S. equity markets.
The Russell Reconstitution plays a critical role in ensuring consistency, transparency and reliability of U.S. equity market measures for global investors.
This closely watched market event impacts more than $9 trillion in investor assets benchmarked to or invested in products based on the Russell U.S. Indexes. The event can create risks for investors who are tracking these indices to ensure they have minimal performance slippage versus their benchmark index. Similarly, it can create opportunities for investors seeking to benefit from the price moves which may be created from the reconstitution.
Countless ETFs, mutual funds and managed asset programs mirror the composition of the Russell U.S. Indexes in their investment funds, structured products and index-based derivatives. With close to 70% of actively-managed institutional U.S. equity assets currently benchmarked to a Russell Index, changes to index composition are apt to reverberate widely across the market.
Comparison of year-to-year changes in the breakpoint between large cap and small-cap sectors serves as a useful gauge of secular growth in market valuations.
Exhibit 1: Historical Maximum and Minimum Market Capitalizations, With and Without Banding
Banding minimizes unnecessary turnover: Any incumbent index member will get moved from the large-cap segment to the small cap segment, or vice versa, only if its newly-evaluated market cap falls outside a 5% band centered around the breakpoint.
Exhibit 2: Historical Breakpoint Between Russell Large Cap and Small Cap Indexes
What Does the Early Reconstitution Analysis Tell Us?
On May 7, known as rank day, FTSE Russell posted its preliminary lists of companies set to enter or leave the Russell 2000 Index. The preliminary list shows dozens of publicly traded banks expected to be removed from the Index in June 2021.
During last summer’s reconstitution in the early months of the COVID-19 pandemic, the smallest market cap in the Russell 2000 dropped to $94.8 million, the cutoff’s lowest point since the Great Recession. Analysts are expecting a high market-cap hurdle in 2021.
Four times during June, preliminary lists of additions and deletions to indexes including the Russell 2000 are made public, per the FTSE Russell’s reconstitution schedule. On June 25, after markets close on the last Friday of the month, the Russell rebalance goes into effect.
Away from the limelight that FAANG stocks and the Nasdaq-dominated stocks get, the small-cap shares also had a tremendous run over the past 12 months. The Russell 2000 Index is up by nearly 100% over the one-year period.
Using CME E-mini Russell 2000 Index Futures Around the Reconstitution
Many investors consider the Russell 2000 Index to be the most comprehensive indicator of the U.S. economy due to its breadth of industries as well as its constituents central exposure to the United States.
The annual reconstitution requires thoughtful and well-executed risk management on the part of investors. It is one of the most significant drivers of short-term shifts in supply and demand for U.S. equities, often leading to sizable price movements and volatility in individual companies or industry sectors.
Investors thinking about rebalancing their index exposures could involve buying all index additions and selling all index deletions, while carefully weighing the trade-offs between tracking error and minimization of price impacts and trading costs. Although reconstitution poses a risk of performance slippage and index tracking error, it also can present opportunities for investors seeking to benefit from share price moves that arise from reconstitution.