As the Russell indices approaches their June 25 rebalance date, it's time to take one last look how this annual reconstitution can be used as a predictive tool in picking stocks. Last week's article showed how boomerang stocks (those falling back into the Russell 2000 from the Russell 1000 due to falling market capitalization) should be avoided after the initial bump from their "addition" to the small-cap benchmark subsides, as they tend to resume what has often been a downward slide.

This week we'll focus on companies that, as a result of positive stock performance, have "graduated" to the Russell 1000 from the Russell 2000. The data show that these stocks tend to continue their winning ways and have historically outperformed the Russell 2000 by 800 basis points over the six-month period following the reconstitution date. The graduate class can be used as an effective screening tool for identifying stocks, along with related option plays, that are likely to deliver positive returns, as evidenced by last year's crop described in a

previous column.

Good Performers Without a Stage

It's interesting to note that the

S&P 500 Index

, which is probably the most popular proxy and benchmark index for large-cap stocks, doesn't contain about 100 of the largest U.S. companies by market cap, including popular names, like

Amazon.com

(AMZN) - Get Report

,

Ameritrade

(AMTD) - Get Report

,

PetSmart

(PETM)

and

Sepracor

(SEPR)

.

(Here is a

full list of stocks that, despite sporting a top market capitalization that makes them among the 500 largest publicly traded companies, are not in the S&P 500 index.)

I point this out to emphasize the influence that inclusion in an index has on stock selection and, ultimately, portfolio performance. The overwhelming tendency to base performance on its relativity to a benchmark leads to most money managers merely hoping to match the market's performance, rather than delivering positive absolute returns.

The dominance of the Russell 2000 and the S&P 500 as the benchmark for small- and large-cap funds, respectively, means that many companies slip into a void between the two indices. This means that despite solid fundamentals and having demonstrated positive returns, they'll get overlooked and become underowned.

To outperform the market, investors need to avoid blindly buying into broad indices and need to be more selective in their stock-picking. The Russell graduating class provides a great starting point for identifying stocks that have a history outperforming both the Russell 2000 and the S&P 500 indices over the six-month period following the reconstitution date.

Historical Repeatability of Graduate Outperformance

Source: Frank Russell Co., and Smith Barney

Click here for larger image.

According to the initial data, there are 72 stocks expected to graduate from the Russell 2000 to the Russell 1000; this is a relatively small class (92 companies graduated last year). But our knowledge is further diminished by the fact that 10 recent initial public offerings are expected to be immediate members.

On the other hand, working with a reduced pool of stocks might actually be good, because for most individual investors, it's unrealistic to buy the group en masse.


Click here for to see full list.

But this year, one edge that previously has helped in making some buying decisions appears to be missing: the tendency of the graduates to come under undue or artificial selling pressure as funds unload the stocks exiting the Russell 2000 in the week before the rebalance date.

Russell Graduates -- Average Performance Relative to Russell 2000

Source: Frank Russell Co., and Smith Barney

Click here for larger image.

Since the May 28 freeze date (when the market caps are set for the rebalance) through June 22, the Russell 2000 has declined 0.5% and is down 5% from its 52-week high. By comparison, the graduate group actually has posted an average gain of 3% over the same time period, and 13 of the graduates, or 17% of them, currently are sitting at 52-week highs. Some of the graduate companies with shares pushing toward new highs include

Urban Outfitters

(URBN) - Get Report

,

Yellow Roadway

(YELL)

and

Akamai

(AKAM) - Get Report

.

Because the market is not offering its usual artificial price discount, it might make sense to sell put options as a means of lowering the effective purchase price. For example, with

Arch Coal

(ACI) - Get Report

hitting a new 52-week high of $35 on Wednesday, you could sell its August $35 put for $1.65 a contract. If the stock is above $35 on the Aug. 20 expiration date, the put will be worthless and your maximum profit is limited to the premium sold. But if the stock moves lower and the put moves into the money, your effective purchase price will be $33.35, or 4.7% below the current market price.

However, for high-beta stocks that can show explosive moves up or down based on news, such as

Martek Biosciences

(MATK)

-- which has tumbled 22% over the last month and now sits just above support at $51 -- it might make sense to buy call options. This will limit the downside risk while offering maximum upside profit potential.

The final membership lists for the Russell indices will be posted on July 6, so we still may see some temporary price dislocation over the next week as funds realign their portfolios toward the rewards of mediocrity. The astute investor will look beyond which companies are going into what indices and ask instead how they got there.

Steven Smith writes regularly for TheStreet.com. In keeping with TSC's editorial policy, he doesn't own or short individual stocks. He also doesn't invest in hedge funds or other private investment partnerships. He was a seatholding member of the Chicago Board of Trade (CBOT) and the Chicago Board Options Exchange (CBOE) from 1989 to 1995. During that six-year period, he traded multiple markets for his own personal account and acted as an executing broker for third-party accounts. He invites you to send your feedback to

steve.smith@thestreet.com.