The Russell 2000 Index Reconstitution

The Russell 3000 Index represents approximately 98% of the listed U.S. equity market. The annual reconstitution of indices such as Russell 1000 and Russell 2000 can traditionally create one of the largest short-term drivers of supply and demand for U.S. equities.

This can create risks for investors who are tracking these indices to ensure they have minimal slippage vs. their benchmark index. Similarly, it can create opportunities for investors seeking to benefit from the price moves which may be created from the reconstitution.

There are several scenarios in which the use of CME E-mini Russell 2000 Index futures can help to mitigate risk for investors tracking the Russell 2000 index and aid investors who are seeking to benefit from price movements of relevant U.S. equities.

Investors who are tracking the index from a long perspective will often hold physical shares in the correct proportions prior to the reconstitution. To eliminate tracking error versus the index, the investor must buy all the additions to the index and sell all the deletions on the cash close of 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 needs to be replicated by the investor’s share hedge. Operationally this means an investor must trade over 2000 stocks and ensure they trade the exact quantity of shares correctly for each individual name. This can be challenging and is susceptible to operational error, which in turn creates tracking error.

The same principle holds true for clients who have short positions, with the added complication that an investor must source all the relevant locations to short each individual name that remains within the index.

Rather than having to execute this trade across 2000 or more individual names, an investor could simply hold a CME E-mini Russell 2000 Index futures contract in lieu of stocks. The benefit of holding a futures position is that the investor does not have to trade the reconstitution themselves. This task has effectively been outsourced to others. The futures contract will track the index and there will be no tracking errors incurred by trying to replicate the reconstitution.

To gain exposure to CME E-mini Russell 2000 Index futures a client has two main options:

• Executing an Exchange for Physical (EFP) which allows them to exchange their portfolio of shares tracking the index for a CME E-mini Russell 2000 Index futures contract, and then carry the resultant futures contract across reconstitution (post reconstitution, the client can then execute another EFP to move their exposure back to a portfolio of shares, should they wish).¹
• Execute a CME E-mini Russell 2000 BTIC (Basis Trade at Index Close) transaction in one direction and trade out of their relevant share portfolio on the close of the cash index. BTIC allows an investor to strike a futures contract off the cash index price. By buying CME E-mini Russell 2000 Index futures via a BTIC transaction and selling a cash portfolio on the close, an investor is replacing their stock position with futures. Conversely, a short investor can execute the opposite trade: sell CME E-mini Russell 2000 Index futures via a BTIC transaction and buy their share portfolio on the cash close. This strategy can be deployed in advance of the reconstitution and can also be averaged over several trading sessions based on execution and market impact preferences.²

Please note CME E-mini Russell 2000 Index futures BTIC transactions are available both on CME Globex trading platform or as a block trade.³ As this is the first reconstitution occurring post the Russell 2000 futures return to CME Group, this is a risk management feature that is available for the first time.

Get more details on BTIC and how it works

For investors managing assets benchmarked to Russell 1000 or Russell 2000 and receiving subscription and redemption flows in the run up to the reconstitution, it may be easier to use Russell Index futures to manage the equitization of those cash flows. This avoids the need to trade a cash basket which has potentially volatile underlying. CME E-mini Russell 2000 Index futures can be traded on CME Globex or, if flows are tied to the close, by executing a BTIC transaction.

Investors whose mandate allows them to trade prior to the reconstitution day have discretion on the composition of the cash basket they trade for equitizing fund cash flows. They can attempt to benefit from the potential price movements of the stocks being added or deleted to the index and trade ahead of time. To manage any notional discrepancy between additions and deletions stocks that an investor trades prior to the reconstitution, the investor can use CME E-mini Russell 2000 Index futures as part of their core holding and easily manage their notional up and down as they trade around the add/delete positions. 

These investors typically predict ahead of time the additions and deletions to the Russell 2000 index and manage these positions in the run up to the constitution becoming formalised. It can often be better to isolate the additions versus a benchmark and similarly, the deletions versus a benchmark. It is often not ideal to manage additions versus deletions solely via outright trades in the underlying stocks. The benchmark that can be used versus either the additions or deletions is the Russell 2000 Index. From a liquidity, ease of execution, capital and transparency perspective this trade is often best implemented by using CME E-mini Russell 2000 Index futures. These futures can be executed intraday to risk manage notional positions around the adds or deletes cash baskets and can also be used targeting the cash close via a BTIC transaction.

Intraday liquidity in small caps tends to be much thinner than large caps stocks. Thus, more volume tends to trade at the close and to some degree at the open. To take advantage of the liquidity found at the close, this can be the optimal time to trade add/delete names ahead of the reconstitution. To remain notional or beta hedged an investor can execute a CME E-mini Russell 2000 Index futures BTIC transaction in the opposite direction.

The Russell 2000 reconstitution is a major event in the U.S. equity calendar, which presents risk management challenges for some and potential alpha trade opportunities for others. CME E-mini Russell 2000 Index futures can be employed in a variety of ways to help either manage these risks or aid in the implementation of alpha trade opportunities. This can be achieved using the liquidity found on CME Globex intraday, by using BTIC transactions to trade futures off the cash close, or by executing an EFP to switch between stock and futures positions.

1. All such EFPs must be executed in accordance with CME Rule 538 (“Exchange for Related Position Transactions”) and the Market Regulation Advisory Notice concerning Rule 538. 

2. 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.
For more information on Rules 538 and 524, please visit the Market Regulation Advisory Notice page on the CME Group website available here.

3. Pursuant to the requirements of CME Rule 524 (“Block Trades”).