Tomorrow, the

Frank Russell Company

begins the annual rebalancing of its 21 different U.S. stock indices, including the

Russell 2000

, which is used as a benchmark for small-cap performance.


Steven DeSanctis
Head of Small-Cap Research,
Prudential Securities

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Essentially, the Russell people take a snapshot of small-cap market value after the close of Thursday's session and use that to determine who is removed and who is added to the indices after the close of trading on June 30. The Russell 2000 is comprised of the bottom two-thirds of the 3000 largest U.S. companies by market cap, while the other Russell indices are assembled based on similar dissections of the market universe.

A preliminary list of those companies added to and dropped from the Russell indices is released on June 8, followed by revised lists one week and two weeks later. Then, on July 1, the new Russell indices go into effect, unchanged until the next year rolls around. The rebalancing creates chaos, because small-cap funds, particularly index funds, often have to reshuffle their portfolios.

Indeed, the annual reshuffling is like making the varsity high school football team. In 1999,

American Stock Exchange

member

Pitt-Des Moines

(PDM) - Get Report

gained 93% on the day it was officially added to the Russell. Last year, software company

ePiphany

(EPNY)

gained 26% in the two weeks between June 30 and July 14, spiking to a 52-week-high of $98.12 in the process. (And just like gridiron high school heroes, both of those names have been trying to relive their glory days; ePiphany closed last week at $15.26 and Pitt, which spiked to $62.50 on the day it was added, hasn't come within $25 of that mark since setting it.)

To help investors understand the Russell reshuffle and how it affects the market,

TSC

talked to Steven DeSanctis, head of small-cap research at

Prudential Securities

. In the most recent

Institutional Investor

poll, DeSanctis was ranked third in the small companies category and just last week, wrote a report about the state of the small-cap world headed into tomorrow's action. (For more on what the reconstituted indices might look like, see this

article by

Justin Lahart

).

TSC: What are you looking for on June 8, when the Russell rebalances?

DeSanctis:

For the Russell 2000, what's going to happen is the highest market cap on the index should be about $1.4 to $1.5 billion. The smallest stocks will be about $135 to $140 million in market cap. And for the index itself, I think technology's weight is going to increase and you end up losing some of the cyclical areas that have actually done quite well recently. So some of the homebuilders potentially move up to the

Russell 1000

, depending on performance, of course. This week, financial services in the benchmark will lose weight and utilities also lose some weight.

TSC: What about Net stocks? They did well in 1999 and left the index, only to return last year after doing so poorly.

DeSanctis:

That's right. Now all these names are coming back. Then again, we don't know because it's all based on May 31 market values and if they drop in the next couple days of trading, anything can happen, the way that this market is.

TSC: Have you seen any difference between this year and last year with how people have been playing the Russell restructuring?

DeSanctis:

From what I'm seeing and what I'm talking to clients about, it seems like people started a little bit early this year -- not that they haven't done that in previous years. I think a lot of people have started very early and one of the reasons why this is occurring is if you look at the Russell 2000, the average market cap is going to drop rather dramatically from about $1 billion to about $735 million just based on April 30 pricing, and that could be quite a bit different also with what happened so far this month. The way the average market cap is going to come down, a lot of small-cap money managers have to get in line with the benchmark so they've been buying these smaller small-cap names.

TSC: Getting in line with the benchmark Russell 2000 isn't an easy thing to do. Last year, how many companies were added?

DeSanctis:

We had 693 new names to the index. So, yes, it was a big reshuffling around.

TSC: What does it mean for stocks to be added to the Russell?

DeSanctis:

When you are a brand-new in, you usually outperform when first coming into the benchmark because the indexers will more than likely buy your stock. Especially if you're a bigger small-cap name, they'll definitely have to go in and buy that name. Actually, we have a report out about the last three years. We looked at the last 10 trading days in the month of June. So when the preliminary list is out, the companies that are being added for the first time outperform by over 7 percentage points during the last two weeks of June. They're actually up 7.27% over that span, over the past three years.

TSC: How should the individual investors play this? Should they get involved in betting on individual companies?

DeSanctis:

You know what? It's too hard. For individual investors, I don't know if it's worthwhile doing it. Like last year in particular, if you look at the last two trading days of June, the 29th and 30th, everything you thought would happen, the reverse occurred. For example, the brand new adds for the index underperformed for the last two days and actually sold off.

The institutional clients start so early, including hedge funds, that when they decide the game is over, you don't really know that until you see these stocks get hit pretty hard. And so it's really hard to play the individual names. I think for my client base, which is more the institutional manager, the key is understanding what the indices are going to look like after reconstitution. So you know this is what the sector bets are, what your size bet is going to be -- that kind of thing.

TSC: What will the sectors look like once it rebalances?

DeSanctis:

Using April 30 prices, and keep in mind a lot has changed in the past month or so, we've got technology gaining 4.3 percentage points, becoming 18.2% of the index based on my own sector mapping. We've got health care losing 1.7 percentage points to about 11.6% of the index. Utilities fall 1.1 percentage points to 3.8%. Financial services loses 2.4 percentage points and will be 12% of the index. Consumer services will gain about 60 basis points and will be about 13% of the index.

TSC: Are people who have already gotten into the small-cap stocks likely to be looking to sell into strength?

DeSanctis:

Yes. I think on the hedge-fund side, the non-traditional small-cap fund managers, I don't think they're going to own these names for much longer. So yes, I'd say that they'd be very likely to reverse their trades. Right now, they're playing this as a trade and once the game is over, which should be shortly, by the end of June, they'll bail out of these things.

TSC: Right before the books close this week, on the 31st, is it possible that people will try to manipulate things and run up some of these names?

DeSanctis:

I don't think you really see that. People made their bets already and people also will wait until late June or when the preliminary list comes out on June 8. So the first day of trading will really be June 11, and maybe you'll see something funky go on then.

TSC: Once they're in the index, in July, what happens then?

DeSanctis:

You kind of see the opposite happen. Some of the brand-new adds sell off a bit in July. Some of the names that are totally getting booted out of the index, even though they've underperformed, you all see them outperform in the month of July. People kind of buy them dirt-cheap. There could be some bargains out there.

TSC: Any particular sectors that might be bargain priced by then?

DeSanctis:

It's really tough to tell now since there's really no telling who will make the index.