The Russell 2000 index is about to undergo a face-lift, and maybe your portfolio should too. At the close of trading on June 25, the Frank Russell Co. will rebalance its small-cap benchmark, along with the less closely followed large-cap Russell 1000 index, in moves that could provide investors with some good buying and shorting opportunities. The shakeup, which comes at this time every year, is significant because roughly $350 billion in assets is benchmarked to the Russell indices. When companies are added or deleted from the index, fund managers must also buy and sell these names, and that can ignite big rallies and big declines in individual stocks. A preliminary list of companies being added or removed is expected to be released on June 11, but analysts are already speculating about what the list will look like. Smith Barney analyst Albert Richards predicts that 278 companies will be added to the Russell 2000 index for the first time this year, including Encore Capital Group ( ECPG - Get Report), Nelnet ( NNI), Whiting Petroleum ( WLL - Get Report) and NetGear ( NTGR - Get Report). Merrill Lynch analyst Satya Pradhuman said that candidates for addition typically rise 5% in the month leading up to the reconstitution. And Richards noted that these stocks typically outperform the Russell 2000 by 175 basis points on average during the first year. Stocks that have grown too big for the Russell 2000 and move into the large-cap Russell 1000 index at the annual rebalance could perform even better. Richards estimates that 68 companies will "graduate" in 2004, including Allmerica Financial ( AFC), Petco , Westar Energy ( WR), Ask Jeeves and CNET Networks ( CNET). "This may be the most fertile list from which to pick new investments," Richards said. "Graduates are the largest stocks, usually have strong fundamentals and tend to outperform all other classes and the broader indices over the following year."
Since 1995, graduates have outperformed the Russell 2000 index by 556 basis points in the year after reconstitution, Smith Barney's research showed. In contrast, companies that are moving back to the small-cap index from the large-cap index have produced poor returns historically. "Boomerangs tend to experience a sudden slide in performance post-May 31. ... That goes well beyond the impact of any negative selection bias," Richards said. On average, these stocks have underperformed the Russell 2000 by about 700 basis points during the first three months. After one year, however, their performance has lagged by a much smaller 35 basis points. When a company's market cap shrinks, it's often a sign that the firm is suffering from some fundamental problem that can take time to resolve, Richards said. "Consequently, the continued underperformance of these companies is no surprise." Prudential Equity Group analyst Steven DeSanctis said this year's "boomerang" list should include 68 companies, including Delta Air Lines ( DAL - Get Report), Readers Digest ( RDA) and Krispy Kreme ( KKD). Meanwhile, some 201 companies are expected to be eliminated from the Russell 2000 entirely, either because they are too small for the index or because they have fallen below $1 a share. These stocks have generally underperformed the index by about 12% in the year after the reconstitution, according to Richards. On the list this year are names such as Bally Total Fitness Broadvision ( BVSN) and Tweeter Home Entertainment ( TWTR). While individual stocks could see some big swings over the next few months, there are fewer names being added and eliminated this year, and that should reduce the impact to the overall market. "This year will be a ho-hum event owing to the fact that the turnover is below the historical average," DeSanctis said. The projected number of additions and deletions this year will be the lowest since 1995, according to ITG, which estimates that 326 stocks will be added and 258 deleted. Changes in sector weights are also expected to be minimal compared with those of prior years. The most notable shift will occur in the technology sector, which is expected to rise to 15.2% of the Russell 2000 index from 14.5%, according to Smith Barney. The financial sector's weighting will increase to 22.4% from 21.7%, while consumer discretionary will fall to 17.8% from 18.9%, and health care will decline to 12.6% from 13.36%.