Top of the Class: Using the Russell Rebalance - TheStreet

Top of the Class: Using the Russell Rebalance

Stocks that graduate to the next level often perform well over the next 12 months.
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Frank Russell Co. performed its annual rebalancing act of its U.S. equity indices on June 30. The changes are made so the indices accurately reflect the 3,000 largest companies in the U.S. stock market by market capitalization.

Most strategies for trading off the rebalance are executed in the weeks and days ahead of the changes, and are merely seeking relatively short-term trading profits. Here's a longer-term strategy to implement after the changes occur.

While the final list won't be officially published until July 9, the transparency of the reconstitution process makes it fairly easy to handicap the expected changes before then. In fact, the calculations used for the rebalance are actually based on closing prices of the last day of trading in May. That gives money managers and traders nearly a full month to adjust and trade stocks based on expected changes. Most index funds will try to delay adjusting portfolios to as close to the effective date as possible so the fund's performance will accurately track their chosen benchmark.

Because an estimated $250 billion in mutual fund money is benchmarked toward the Russell indices, a stock's addition or deletion can have a substantial impact on the share price. It's understandable that many of the companies slated to be added begin to exhibit some "creep" in their stock price as people try to get ahead of the expected price pop.

Moving On Up ...

But I want to focus on a particular subset of companies, namely those that have become too big for the Russell 2000 small-cap index and are moving into the Russell 1000. That these names have grown too large for the Russell 2000 means almost by definition that they've been some of the best performers over the past 52 weeks, have some of the best fundamentals and are therefore great candidates for future price gains.

"We've dubbed these stocks the 'Graduates' since they are moving up to the next level", says Dr. Albert Richards, an emerging-growth strategist with Smith Barney. Richards has performed some crack research on the past 12 years of graduating classes, and his number-crunching revealed some interesting results.

For instance, he found that for the 30-day period prior to the rebalancing, the Graduates actually underperform the Russell 2000 by an average of 3.2%. "In my opinion, this is due to the fact that there is much more money benchmarked to the Russell 2000 than the 1000. Most mid-cap managers use the S&P 400, hence a removal from the 2000, which does not guarantee an addition to the S&P mid-cap, causes abnormal selling pressure," says Richards. The selling and price declines accelerate in the last seven trading days as small-cap managers jettison these newly designated mid-caps from the portfolio.

... and Leaving Their Friends Behind

Over the past 12 years, Richards found, this group rose an average of 17.3% in the first year after "graduation." That's an average of 8.8% better than the Russell 2000 and 5.2% better than the Russell 1000 over the same relative time periods. Again, this can be attributed to the "by definition" positive fundamentals and performance being exhibited in the prior year.

This year, 92 stocks will be graduating -- a relatively small class, but still too large for most investors to buy the whole group. I'd suggest creating a mini-basket of 10 stocks from the group.

For my picks, I had just a few simple criteria:

The share prices declined in the prior month, indicating they may be artificially depressed as a result of the above-mentioned selling pressure;

The stocks have options that trade on them, because I want to buy calls rather than the underlying shares to reduce my total capital outlay; and

I wanted a diversified group with a sector representation similar to the index at large.

The table below lists my 10 choices and gives their percentage decline from May 30 to July 1. During that same time period, the Russell 2000 rose 1.8%.

Remember, this isn't the only -- or possibly even the best -- way to play this strategy. The main point is that we're using the Russell rebalance as a screening tool and taking advantage of the fact that it has already done a lot of work for us by identifying potential winners.

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 May 1989 to August 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.