The Russell 2000 Index Reconstitution – Because markets change

  • The Russell indices are among the most widely used benchmarks for measuring US equity market performance.
  • FTSE Russell reconstitutes its indices annually, each June, which presents risk management challenges for some and potential alpha trade opportunities for others.
  • Reconstitution day is typically one of the highest trading-volume days of the year in US equity markets - Here we explore ways to manage exposure and implement trade ideas using E-mini Russell 2000 Index Futures and Basis Trade at Index Close (BTIC) transactions.

Why index reconstitution?

The US equity market is the largest publicly traded securities market in the world. The rebalance happens, simply put, because markets change and evolve. The annual reconstitution ensures that the Russell US Indices reflect changes in the US equity markets over the preceding year in accordance with the transparent, public, rules-based methodology.1

During the multi-week rebalancing process concluding on June 25, 2021, changes in market capitalization, sector composition, company rankings and style orientation are captured through the new index composition allow the different Russell US Indices to remain representative of the benchmarks they are targeting.

Why is this important for investors?

The annual reconstitution 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 company names or industry sectors. The final day of the reconstitution is typically one of the highest trading-volume days of the year in US equity markets.

The Russell Reconstitution plays a critical role in ensuring consistency, transparency & reliability of US equity market measures for global investors.

This closely watched market event impacts more than $9 trillion in investor assets benchmarked to or invested in products based on the Russell US Indices. The event can create risks for investors who are tracking these indices to ensure they have minimal performance slippage versus their benchmark index. Similarly, it can create opportunities for investors seeking to benefit from the price moves which may be created from the reconstitution.

Countless ETFs, mutual funds and managed asset programs mirror the composition of the Russell US Indices in their investment funds, structured products and index-based derivatives. With close to 70% 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.2

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.

Exhibit 1--Historical maximum and minimum market capitalizations, with and without banding

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 centered around the breakpoint. See Exhibit 2.

Exhibit 2 -- Historical breakpoint between Russell Large-Cap and Small-Cap indices

Source: FTSE Russell

What does the early reconstitution analysis tell us?

On May 7, known as rank day, FTSE Russell posted its preliminary lists of companies set to enter or leave the Russell 2000 Index. The preliminary list shows dozens of publicly traded banks expected to be removed from the Index in June 2021.

During last summer’s reconstitution in the early months of the COVID-19 pandemic, the smallest market cap in the Russell 2000 dropped to $94.8 million, the cut-off’s lowest point since the Great Recession. Analysts are expecting a high market-cap hurdle in 2021.

Each Friday in June, preliminary lists of additions and deletions to indexes including the Russell 2000 will be made public, per the FTSE Russell’s reconstitution schedule. On June 25, after markets close on the last Friday of the month, the Russell rebalance goes into effect.

Away from the limelight that large-cap technology stocks, including FAANG stocks, received, the small-cap shares also had a tremendous run over the last 12 months. The Russell 2000 Index is up by nearly 100 percent over the one-year period.

Using CME E-mini Russell 2000 Index futures around the reconstitution

Many investors consider the Russell 2000 Index to be the most comprehensive indicator of the US economy due to its breadth of industries as well as its’ constituents central exposure to the United States.

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.

Investors thinking about rebalancing their index exposures may consider buying all index additions and selling all index deletions. However, they must carefully weigh 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 the reconstitution.

E-mini Russell 2000 Index  futures (RTY) may be useful for both purposes.  For market participants looking to manage additions and deletions, the Basis Trade at Index Close (“BTIC”)3 mechanism – which permits RTY contracts to be traded at prices quoted as spreads versus the day’s official index closing value – may provide 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.

CME Group’s RTY contract can be a cost-efficient tool for shifting 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.

Tracking the Russell 2000 Index on Reconstitution Day

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) 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).4,5

    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.6

    Get more details on EFP and how it works

Investors tracking the Russell 2000 Index prior to the 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 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 spread 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).7

RTY contracts likewise can furnish users with a means to trade intra-market price discrepancies. A trader can enter a calendar spread, for example, 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.8

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 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.

References

  1. https://www.ftserussell.com/resources/russell-reconstitution
  2. https://www.ftserussell.com/indexes/index-linked-products/ftse-russell-etfs
  3. Read more at: https://www.cmegroup.com/trading/equity-index/btic-block-trades.html
  4. 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.
  5. Pursuant to the requirements of CME Rule 526 (“Block Trades”).
  6. 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.
  7. 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, visit: https://www.cmegroup.com/clearing/margins/inters.html#pageNumber=1
  8. 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, visit: https://www.cmegroup.com/clearing/margins/intras.html#pageNumber=1&sortField=exchange&sortAsc=true&exchange=CME&sector=EQUITY+INDEX&clearingCode=RTY

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