Never smooth, the annual rebalancing of the

Russell 2000

could prove particularly rocky this year. Look for a month of big moves in the small-cap stocks the index tracks.

On the last trading day of June, investment management and consulting firm

Frank Russell

rejiggers the small-cap benchmark, along with the less-closely followed, large-cap

Russell 1000

index. The changes are based on what the market looked like the last trading day of May. Stocks in the Russell 2000 whose market capitalizations have grown large enough get shifted up into the 1000 index. Companies whose market caps have shrunk too much are dropped outright. New companies get added.

Because the reconstitution happens only once a year, the changes can be big: Last year about a quarter of the companies in the Russell 2000 got replaced by new names. It ends up being a pretty big headache for managers of Russell 2000 funds, who must buy stocks being added to the index and sell stocks being taken out. Naturally, there are people who try to front-run this, buying likely additions early, maybe shorting some likely deletions, hoping to make a little coin. Already there are lists of stocks likely to get included in the index getting passed around.

And this year, the changes may be more sweeping than ever before, observers say. That's because the small tech stocks whose capitalizations skyrocketed during the

Nasdaq's

run-up of 1999 and 2000 have seen their worth plummet back to earth. That could mean renewed selling in small tech names about to be booted and buying in the Old Economy outfits that will replace them.

Boomerang Effect

Keep in mind that there's been a lot of carnage in the technology arena since the Russell's last rebalancing. Around 3400 on May 31 last year, the

Nasdaq

was well off its highs, but still about 37% above where it was a year previous. It has fallen 35% since. The most speculative names have fared even more poorly --

TheStreet.com Internet Sector

index has dropped 65%. With the popping of the bubble in tech stocks, the way the Russell looks July 1 is going to be a lot different than how it looks now.

Diverging
Russell 2000 vs. TheStreet.com Internet Sector, one year

"A lot of these smaller tech tocks that have fallen 70%, 80% are going to be out of the index," says Ananth Madhavan, managing director of research for

ITG

. "We expect that 27% of the index weight is going to get deleted."

The dot-com sector will be particularly hard hit. Of the 146 Internet companies in the index, only about half will make the cut, according to

Merrill Lynch's

equity derivatives group. Companies like

Sportsline.com

(SPLN)

,

Drugstore.com

(DSCM)

and

Barnes & Noble.com

(BNBN)

will be shown quietly the exit. Entering the index will be a number of Old Economy names -- mostly financial and consumer cyclical companies. Here's where the fun begins.

How to Play It

The criteria for getting into the Russell 2000 is market cap. This year the cutoff point looks like it will be around $140 million, according to Merrill. But what determines a company's weight in the Russell indices is not market capitalization (as in the

S&P 500

), but market float -- the value of the shares that are available for trading.

As it happens, the dot-com names generally have really small floats, often less than half of the total shares outstanding. It's a ploy that helped them rocket higher on the way up: With only a relative handful of shares trading, supply wasn't adequate to meet demand and prices soared. Because of these thin floats, these stocks didn't rank as highly as they might have in the Russell 2000, and made up a smaller proportion of the index. (Even then, thin floats will probably put the share prices of Internet companies going out of the Russell at risk when index managers start dumping them.)

The companies coming into the index, according to Merrill equity derivative strategist Steve Kim, have relatively deeper floats and relatively lighter daily trading volume. "It seems that there could be an imbalance between supply and demand," says Kim. In other words, stocks entering the Russell 2000 this year could see some pretty big gains.

Risk and Reward

Investors trying to take advantage of the annual Russell effect now may be running greater risks than in past years, however. Those tech shares that look like they're going to get taken out remain extremely volatile, and many of them could easily tack on the gains they need to keep them in the index over the next few weeks. "The slightest whiff of good news, those stocks can head a lot higher," says Madahavan. "It's going to be a difficult year to play the Russell strategy."

Consider a stock like

Viant

(VIAN)

. Shares of the Internet consulting firm have risen nearly 60% in the last few weeks, bringing its market cap up to $130 million -- nearly high enough to keep it in the Russell.

Given the high degree of uncertainty about which stocks will end up in the Russell this year, it's likely that not as many people are playing the rebalancing game early as in the past, choosing instead to wait until the close May 31, when it will be a lot clearer who will make the cut. All of which could make for a lot of fireworks in the market the next day.