Russell U.S. Index Reconstitution

Simply put, because markets change. There are over 10,000 publicly traded companies in the US market. Their sizes change continuously.  Thus, every June the benchmark administrator, FTSE International Limited, rebalances the indexes in accordance with the published benchmark methodology, to ensure they remain representative of the market's state.²

During the multi-week rebalancing process, changes in market capitalization, sector composition, company rankings and style orientation are captured so as to be reflected in the new index composition.  When the rebalancing concludes in late June, the entire family of Russell US Indexes is recast to reflect changes in the US equity markets over the preceding year.

The transparent rules-based methodology used to maintain and reconstitute the Russell US Indexes is designed to ensure that the process runs smoothly for investors.

The process is closely watched by market participants, and the final day of the reconstitution, occurring this year on Friday, 28 June, is typically one of the highest trading-volume days of the year in US equity markets.

Firstly, the universe of publicly-traded US companies is created, along with each company’s market capitalization.  This universe is then refined by removing securities that are ineligible for index inclusion due to company structure, size, share type, exchange or other pre-defined criteria. The remaining companies are then ranked by total market capitalization. The largest 3,000 become members of the Russell 3000® Index. In turn, these 3,000 component firms are segmented by size to determine the breakpoint between the large cap Russell 1000® Index and the small cap Russell 2000® Index. With index constituents thus assigned, each company’s weighting within its assigned index is based on its float-adjusted market capitalization.

Comparison of year-to-year changes in the breakpoint between large cap and small cap sectors makes a useful gauge of secular growth in market valuations.  See Exhibit 1.

Source: FTSE Russell

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 its newly-evaluated market cap falls outside a 5% band centred around the breakpoint.  See Exhibit 2.

The 2019 Russell index reconstitution calendar is as follows:

• May 10 – “Rank Day” – Index eligibility, membership and rankings are determined on the basis of market capitalizations at market close. The largest 3,000 companies form the preliminary reconstitution portfolio.
• June 7 – Preliminary index addition and deletion lists are posted to the FTSE Russell website after 6PM US Eastern time.³
• June 14 & 21 – Updates to index additions and deletions are posted to the FTSE Russell website after 6PM US eastern time.
• June 28 – Index reconstitution is finalized after close of trading.
• July 1 – Equity markets open with the newly-reconstituted Russell US Indexes.

This year, FTSE International Ltd has fine-tuned the reconstitution process so that additional procedural steps will apply to any companies that have had share trading suspended.

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 US equities, often leading to sizable price movements and volatility in individual companies or industry sectors.

Countless ETFs, mutual funds and managed asset programs mirror the composition of the Russell US Indexes in their investment funds, structured products and index-based derivatives. With 67% of actively-managed institutional US equity assets currently benchmarked to a Russell index, changes to index composition are apt to reverberate widely across the market.

Such investors may think about rebalancing their index exposures which could involve buying all index additions and selling all index deletions, while carefully weighing the trade-offs between tracking error and minimization of price impacts and trading costs. Although reconstitution poses risk of performance slippage and index tracking error, it also can present opportunities for investors seeking to benefit from share price moves that arise from reconstitution.

CME E-mini® Russell 2000® Index (“RTY”) futures may be useful for both purposes.  For market participants looking to manage additions and deletions, the Basis Trade at Index Close (“BTIC”)⁴ mechanism -- which permits RTY futures to be traded at prices quoted as spreads versus the day’s official index closing value -- an alternative to trading cash baskets. To meet index tracking objectives, while potentially adding value and minimizing transaction costs, trading at market close on the rebalance date often emerges as a more efficient route to achieving the desired equity exposure.

Long holders of index exposure often hold physical shares in the correct proportions prior to reconstitution. To eliminate index tracking error, such investors must buy all index additions and sell all index deletions on the cash close of the reconstitution day.  Further, the index weighting is apt to change for potentially each incumbent stock that remains as an index component after reconstitution; these re-weightings too must be replicated by the investor’s hedge. Operationally this means an investor may have to trade over 2,000 stocks to ensure that the exact share quantity for each individual name is achieved.

The same holds for those carrying short index exposures, with the added complication that any such investor must source all relevant locations to sell short each individual name that remains in the index.

In either case, the adjustment is susceptible to operational error, which may turn into index tracking error.

Rather than executing the trade across 2000 or more individual names, an investor could hold RTY futures in lieu of stocks. The benefit of holding a futures position is that the investor does not have to trade the reconstitution itself. The futures contract design is such that it will track the index with no slippage incurred through physical replication of the index reconstitution.

A market practitioner may gain exposure to RTY futures via two avenues:

• An Exchange for Physical (EFP) trade allows the 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.
• A BTIC transaction in RTY futures allows an investor to enter a futures position by reference to the closing value of the index itself.  By buying RTY futures via a BTIC transaction and selling a comparably sized cash portfolio on the close, for instance, the investor can replace the stock position with futures. Conversely, a short holder of index exposure can sell RTY futures 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 accord 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 large enough to meet block trading standards).

In the run-up to 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 (“RS1”) futures or RTY futures, respectively, to manage equitization of those cash flows.  This avoids the need to trade cash index baskets with potentially volatile prices.

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  futures as part of the core portfolio holdings to better manage notional discrepancies between additions and deletions of index constituent stocks.

Typically, such investors attempt to predict in advance additions and deletions to the Russell 2000® index and to manage these positions in the run-up to reconstitution.  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 to 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 RTY futures.

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. Liquidity at the closing bell makes this the most opportune time to trade index additions and deletions ahead of the reconstitution. In either case, an offsetting BTIC trade in RTY futures offers a convenient tool for the investor who wants to remain hedged, whether in notional exposure terms or in beta exposure terms.

1. www.ftserussell.com/press/ftse-russell-announces-2019-russell-us-indexes-reconstitution-schedule
2. See FTSE Russell Governance Framework v2.0, February 2019, available at: https://research.ftserussell.com/products/downloads/FTSE_Russell_Governance_Framework.pdf?_ga=2.53193576.1381968716.1560171081-249302139.1556542049
3. www.ftserussell.com/resources/russell-reconstitution
4. Read more at: https://www.cmegroup.com/trading/equity-index/btic-block-trades.html

This information was obtained from sources believed to be reliable, but we do not guarantee its accuracy. Neither the information nor any opinion expressed therein constitutes a solicitation of the purchase or sale of any futures or options contracts.