- Many investors consider the Russell 1000, 2000, and 3000 indices to be the most comprehensive indicator of the U.S. economy due to their breadth of industry coverage and the index constituents central exposure to the U.S. equity market.
- The annual Russell Reconstitution, concluding this year on June 23, ensures that changes in market capitalization, sector composition, company rankings, and style orientation are captured such that the indices remain representative of the markets they are targeting.
- The Reconstitution presents risk management challenges for some and potential alpha trade opportunities for others. It is a time to look back at the previous year's U.S. equity market story, where we saw defensive industries, such as Consumer Staples and Health Care, outperform the broader index during volatile markets.
- Reconstitution day is typically one of the highest trading days of the year in U.S. equity markets. Discover how to effectively manage exposure and implement trade ideas using E-mini Russell 2000 Index futures.
Mapping the U.S. market since 1984
The Russell indices provide investors with a comprehensive representation of the world’s largest and most liquid U.S. equity market. They consist of the well-known Russell 1000 (large-cap) and Russell 2000 (small-cap) sub-indices, as well as their growth and value style components. When together they make up the Russell 3000. They are among the most widely used benchmarks for measuring U.S. equity market performance.
A benchmark for U.S. small-cap stock performance, the Russell 2000 index is a broad-based market capitalization-weighted index consisting of the lower ~2,000 small-cap stocks. CME Group E-mini-Russell 2000 Index futures (RTY) and options on futures can be a cost-efficient tool for managing risk and a convenient alternative to cash market instruments. Among RTY’s market characteristics are deep liquidity and substantial open interest – two key features for anyone concurrently trading futures and cash index exposures.
CME Group E-mini and Micro E-mini Russell 2000 Index futures average daily volume and open interest (YTD)
The 35th annual Russell Reconstitution
Simply put, the rebalances happens because markets change and evolve. Successful companies grow, resulting in a rise in their stock price and, consequently, a rise in capitalization. Conversely, other companies are less successful and their stock price declines.
Annual reconstitution ensures that the Russell indices reflect the changes in the U.S. equity markets over the preceding year, in accordance with transparent, public, and rules-based methodology. On a predefined schedule, securities are added and removed to and from the index, and the weights among the securities in the index are then adjusted.
Reconstitution started with Rank Day on Friday, April 28, when the largest U.S. companies were lined up to form the initial portfolio. On May 19, FTSE Russell posted preliminary lists of the companies set to enter or leave the U.S. broad market Russell 3000 index, marking the start of its 35th Annual Russell U.S. Index Reconstitution. The newly reconstituted indices take effect after the close of U.S. equity markets on Friday, June 23.
Why it matters
The annual reconstitution is one of the most significant drivers of short-term shifts in supply and demand for U.S. equities, often leading to sizable price movements and volatility in individual company names or industry sectors. The final day of the reconstitution is typically one of the highest trading volume days of the year in U.S. equity markets.
Approximately $12 trillion is benchmarked to these indices through passive investment products like index funds, mutual funds, and exchange-traded funds, which mirror the composition of the Russell U.S. indices in their products.
The event can create risks for investors tracking these indices as they need to ensure they have minimal slippage versus their benchmark.
With close to 70% of actively managed institutional U.S. equity assets currently benchmarked to a Russell index, the rebalance can create opportunities for investors seeking to benefit from the price moves, which may be created from the reconstitution. Prior to index reconstitution, in an attempt to benefit from price movements in stocks being added or deleted to the index, an investor can use RTY contracts to better manage notional discrepancies between the additions and deletions of index constituent stocks.
Using CME Group E-mini Russell 2000 Index futures around the reconstitution
Investors with a long position thinking about rebalancing their index exposures may consider buying all index additions and selling all index deletions. Each stock that remains in the index is likely to change its percentage index weight and needs to be replicated by the investor. Operationally, an investor must trade over 2,000 stocks in the exact quantity for each individual name.
The same applies for short positions, with the added complication that an investor must locate a source to borrow the relevant shares to short each individual name that remains within the index, often in less liquid names. In either case, the adjustment is susceptible to operational error, which may lead to index tracking error.
CME Group E-mini Russell 2000 Index futures (RTY) may be an especially useful tool for managing additions and deletions. The benefit of holding a futures position is that the investor does not have to trade the reconstitution themselves; the futures contract will track the index and there will be no tracking errors incurred by trying to replicate the reconstitution.
On the reconstitution day itself, the Basis Trade at Index Close (BTIC) mechanism permits RTY contracts to be traded at a spread to the day’s official index closing value and serves as an alternative to trading many cash baskets. It minimizes transaction costs and is a more efficient route to achieving the desired equity exposure.
What does early reconstitution analysis tell us?
Preliminary results for this year’s reconstitution reveal the U.S. broad market decreased modestly in size, with the total market capitalization of the Russell 3000 index down 1.6% from $44.9 trillion as of last year’s rebalance to $44.2 trillion based on this year’s rank day of April 28. The total market capitalization of the Russell 2000 index decreased 10% from $3 trillion as of last year’s reconstitution to $2.7 trillion.
Comparison of year-to-year changes in the market capitalization breakpoint, which separates between large-cap and small-cap sectors, makes a useful gauge of secular growth in market valuations. This year, the breakpoints separating small-caps (Russell 2000 index) and large-caps (Russell 1000 index) decreased by 8.7% to $4.2 billion, following a volatile year in U.S. equity markets, where small-cap stocks underperformed large-cap stocks.
Market Capitalization Breakpoint between Russell Large-Cap and Small-Cap indices
Banding minimizes unnecessary turnover. Any incumbent index member will get moved from the large-cap segment to the small-cap segment, or vice versa, only if it’s newly evaluated market cap falls outside a 5% band cantered around the breakpoint.
Historical market capitalizations and breakpoints
The Russell 2000 represents 8% of the Russell 3000 index. With the largest company in the index valued at $6 billion (Intra-Cellular Therapies) and the smallest company at $159.5 million (Protalix Biotherapeutics).
- A total of 297 companies will be joining the Russell 2000 index, with 25 dropping down from the Russell 1000 index/Russell MidCap index, and 192 shifting up from the Russell Microcap index. There are 81 companies allocated to the Health Care industry, 34 allocated to the Financials industry, and 25 Industrials sector.
- Three IPOs are being added to the Russell 2000, two from Industrials and one from the Energy industry, while 73 companies are joining from outside the Russell U.S. indices universe.
- Russel 2000 has 192 companies departing the index. While 24 companies are moving to the Russell 1000 index, in particular, Health Care, Consumer Discretionary, and Financials industries), 83 are moving to the Russell Microcap index, and another 85 companies are leaving the Russell U.S. indices universe altogether.
- The largest industry in the Russell 2000 remains Industrials at 17.7%, increasing slightly from 17.5%. This is closely followed by Health Care at 17.4% and Financials at 14.2%. The largest increase was Technology, going from 10.6% to 11.8%, while the largest decrease was Consumer Discretionary, going from 13.9% to 13.3%.
U.S. total market size impacted by volatility
Over the past year, high inflation, rising interest rates, and a deteriorating global economic outlook have taken a considerable toll on U.S. equities. For the year ending April 28, the Russell 2000 index was down 3.6%.
Large-caps and growth dominated U.S. market gains in Q1, with most of their outperformance coming amid a massive flight from risk triggered by serial U.S. bank failures in March, as investors flocked to tech and other sectors perceived as less vulnerable to potential economic and credit-market shocks.
Losses were bigger for small-cap industries than their large-cap peers for the 12-month period. A closer look at Russell 2000 industry performance for the one-year period illustrates Industrials was the top performing sector in the index. Several cyclical industries have rebounded in the year-to-date rally, with Consumer Discretionary and Health Care outperforming the broader index for the one-year period.
Russell 2000 Industry performance
Tracking the Russell 2000 index on reconstitution day
The annual reconstitution requires thoughtful and well-executed risk management on the part of investors. It is one of the most significant drivers of short-term shifts in supply and demand for U.S. equities, often leading to sizable price movements and volatility in individual companies or industry sectors.
Long holders of index exposure often hold physical shares in the correct proportions prior to reconstitution. To eliminate tracking error versus the index, the investor must buy all the additions to the index and sell all the deletions at the cash close on the reconstitution day. Furthermore, each stock, which remains in the index, is likely to change its percentage weight higher or lower, and this change in weight also needs to be replicated by the investor. Operationally, this means an investor must trade over 2,000 stocks and ensure they trade the exact quantity of shares correctly for each individual name.
The same principle holds true for clients who have short positions, with the added complication that an investor must locate a source to borrow the relevant shares to short each individual name that remains within the index.
In either case, the adjustment is susceptible to operational error, which may lead to index tracking error.
Rather than having to execute trades across 2,000 or more individual names, an investor could simply trade E-mini Russell 2000 Index futures (RTY) contracts in lieu of stocks. The benefit of holding a futures position is that the investor does not have to trade the reconstitution themselves. The futures contract will track the index and there will be no tracking errors incurred by trying to replicate the reconstitution.
A long holder may replace their physical exposure with RTY exposure via two avenues:
- A BTIC (Basis Trade at Index Close)1 transaction in RTY contracts allows an investor to enter a futures position by reference to the closing value of the index itself. By buying RTY contracts via a BTIC transaction and selling a comparably sized cash portfolio on the close, for instance, the investor can replace the stock position with minimal slippage. Conversely, a short holder of index exposure can sell RTY contracts via a BTIC transaction and buy in shares on the cash close. This strategy can be deployed in advance of the reconstitution and can be averaged over several trading sessions in accordance with the investor’s preferences regarding execution costs and market impact costs. BTIC transactions may be executed either on the CME Globex electronic trading platform or as privately negotiated block trades (if the transaction is large enough to meet block trading standards).2,3 Get more details on BTIC and how it works
- An Exchange for Physical (EFP) transaction allows an investor to exchange shares for an equivalently scaled number of RTY contracts, and then to carry the resultant futures position through the index rebalancing. Following index reconstitution, the investor may either execute a second EFP trade to move the index exposure back into a portfolio of shares or may continue to hold the index exposure in futures contract form for better capital efficiency. This process would hold true for BTIC as well.4 Get more details on EFP and how it works
Investors tracking the Russell 2000 Index prior to reconstitution day
Some investors may carry mandates that allow discretion, prior to index reconstitution, as to the composition of the cash index baskets that may be used for equitizing fund cash flows. In effect, any such investor is permitted to attempt to benefit from price movements in stocks being added or deleted to the index. The investor can use RTY contracts as part of the core portfolio holdings to better manage notional discrepancies between the additions and deletions of index constituent stocks.
Investors seeking to trade the potential price movements of the adds/deletes
Typically, such investors attempt to predict in advance, the additions and deletions to the Russell 2000 index and manage these positions in the run-up to the constitution becoming formalized.
Especially in the small- and mid-cap equity share arena, it is often tactically preferable to trade addition candidates versus the benchmark and deletion candidates versus the benchmark, rather than to trade the prospective additions versus prospective deletions via outright trades in the underlying stocks. From the standpoint of reliable liquidity, ease of execution, capital efficiency, and transparency of pricing, this can be well implemented with CME E-mini Russell 2000 Index futures.
These futures contracts can be executed intraday to manage notional risk around cash basket adds or deletes and can also be used to target the cash close via a BTIC transaction.
Managing liquidity in less liquid names
A related challenge is that intraday liquidity in small-cap shares tends to be much thinner than in large-caps stocks. Additionally, traffic in small-cap stocks, more than in large-caps, tends to be concentrated at the daily close and to a slightly lesser degree at the daily market open. Trade at Cash Open (TACO) transactions allow traders to execute a basis trade on the Russell 2000 futures relative to the day’s official cash index opening level before the market open.
Liquidity at the opening or closing bell can mean that this is the most opportune time to trade index additions and deletions ahead of the reconstitution. In either case, an offsetting TACO or BTIC transaction in RTY contracts can offer a convenient tool for the investor who wants to remain hedged, whether in notional exposure terms or in beta exposure terms.
Market capitalization spread strategies
In addition to allowing market participants to hedge macro exposures or anticipated directional movements in the Russell 2000 index, RTY contracts can provide a cost-efficient vehicle to assist with market capitalization spread strategies. For example, a portfolio manager expecting small-cap stocks to outperform large-cap stocks could enter an intermarket spread5 strategy combining the purchase of RTY contracts and sale of an equivalently sized number of E-mini S&P 500 Index futures (ES) contracts.
At this writing, the CME Clearing margin spread credit is 80% for a position scaled to 2 RTY long (short) versus 1 ES short (long).6
RTY contracts likewise can furnish users with a means to trade intra-market price discrepancies. For example, a trader can enter a calendar spread to buy September RTY contracts and sell an equivalent exposure in December RTY contracts, if an opportune price discrepancy emerges between the two delivery months.
The Exchange’s listings include companion options on RTY futures, enabling a wide array of option spread strategies and Russell 2000 index volatility plays. CME Group also offers futures products based on the Russell 2000 Growth index and the Russell 2000 Value index, potentially useful for many purposes, including cash equitization solutions and tactical asset allocation.
In the run-up to the reconstitution, investors managing assets benchmarked to the Russell 1000 index or Russell 2000 index, and receiving subscription and redemption flows, may find it easier to use E-mini Russell 1000 Index futures (RS1) or the E-mini Russell 2000 Index futures (RTY), respectively, to manage equitization of those cash flows. This may help avoid the need to trade cash index baskets with potentially volatile prices. E-mini Russell 1000 and 2000 Index futures can be traded on CME Globex or, if flows are tied to the close, by executing a BTIC transaction, or via block and EFP transactions.
To learn more about the E-mini Russell 2000 Index futures, visit cmegroup.com/Russell2000.
- Read more about BTIC transactions.
- All BTIC transactions must be executed in accordance with CME Rule 524.B. (“Basis Trade at Index Close (“BTIC”) Transactions”), the Market Regulation Advisory Notice concerning Rule 524 and the provisions in the applicable product chapter.
- Pursuant to the requirements of CME Rule 526 (“Block Trades”).
- For information on exchange-for-related-position transacting, including EFRPs, here: See also CME Group, Block Trades, Market Regulation Advisory Notice RA1906-5, and Rule 538.
- As with intermarket spread positions, potentially significant margin offsets may apply to intra-market calendar spread positions. For current information on margin credits that CME Clearing applies to intra-market calendar spread positions, click here.
- Performance bonds, also known as margins, are deposits held at CME Clearing to ensure that clearing members can meet their obligations to their customers and to CME Clearing. Performance bond requirements vary by product and by market volatility levels and are subject to review and revision by CME Clearing. For up-to-date information regarding margin credits on intermarket spread positions, click here.
E-mini Russell 2000 futures
All examples in this report are hypothetical interpretations of situations and are used for explanation purposes only. The views in this report reflect solely those of the author and not necessarily those of CME Group or its affiliated institutions. This report and the information herein should not be considered investment advice or the results of actual market experience.