What the 2020 Russell Reconstitution Tells the Market

  • The Russell US Indexes annual reconstitution process is critical to maintaining accurate representation of US equity markets
  • The reconstitution is a major event in the US equity calendar, presenting risk management challenges for some and potential alpha trade opportunities for others.
  • Here we explore ways to manage exposure and implement trade ideas using CME’s E-mini Russell 2000 Index futures.

The Russell US Indices were reconstituted at the close of trading on Friday, June 26, concluding an annual multi-week process during which FTSE International Ltd, the index administrator, made rule-based changes. The newly rebalanced Russell US Indices took effect on Monday, June 29, and will remain in place for 12 months. 

Changes in market capitalization, sector composition, company rankings, and style orientation are reflected in the new index composition.

This closely watched market event impacts more than $9 trillion1 in investor assets benchmarked to or invested in products based on the Russell US Indexes. 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.

The key features of this year’s reconstitution reveal much about the dynamism of the US equity market 2. Among them:

  • The market shrank slightly from a year ago, with the total market cap of the Russell 3000 Index down from $31.7 trillion as of last year’s rebalance to $31.4 trillion as of this year’s rank day (May 8, 2020).
  • The largest six companies remained unchanged since last year’s reconstitution. Microsoft is again the largest company in the index, followed by Apple, which is now the second largest company in the index after trading spots with Amazon.com.
  • For the first time ever, there are companies exceeding $1 trillion in total market cap: Microsoft, Apple, and Amazon.
  • The total combined market cap of the top 10 companies has grown 23.3% since last year’s reconstitution.
  • The breakpoint between large-cap and small-cap decreased from $3.6 billion in 2019 to $3.0 billion.
  • The smallest company in the Russell 2000 at this year’s reconstitution (Limestone Bancorp) now stands at $94.8 million market cap, a nearly 38% decline from 2019 and the first time since 2009 the smallest stock, by market capitalization, is less than $100 million.
  • Six IPOs were added to the Russell 2000, all classified in the Health Care sector. No IPOs were added to the Russell 1000 Index this year.

Breakpoints

The 2020 Russell Index Reconstitution underscores a growing gap between the largest and smallest US stocks.

While overall capitalization for the US equity market stayed relatively flat this year, there was a notable divergence between the large- and small-end of the US equity market, driven by the relative strength of US large-caps over the past year. The big got bigger and the small got smaller.3

Representing the US large-cap market segment, the total market cap of the Russell 1000 Index increased 0.7% from $29.3 trillion as of last year’s reconstitution to $29.5 trillion. Additionally, the total market capitalization of the Russell 2000 Index, representing the US small-cap market segment, decreased 19.7% from $2.4 trillion as of last year’s reconstitution to $1.9 trillion.

Year-to-year changes in the breakpoint between the Russell 1000 and the Russell 2000 – i.e., the market capitalization that demarcates the boundary between large-cap and small-cap sectors – are a useful gauge of secular growth in market valuations. Reflecting a challenging 12 months for US small-cap shares, the latest reconstitution saw the breakpoint decrease by more than 16%.

Exhibit 1 – Breakpoints between Russell 1000 and Russell 2000 Index

Source: FTSE Russell. Reflects data as of May 10, 2019 and May 8, 2020, respectively.

A difficult start for the Russell 2000

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

After a relatively flat start to the year, the world’s equity indexes plummeted with alarming speed and depth during 2020’s opening quarter. The small-cap Russell 2000 was hit the hardest among equity indices as sections of the economy were shut down by the pandemic. The 30.6% first-quarter decline for the Russell 2000 was the largest quarterly loss for the small-cap index in its more than 40-year history.

As might be expected in a steep bear market, small caps bore the brunt of the decline on both a domestic and global level. The farther down the market capitalization range one went in the U.S., the worse the result. Large-caps lost the least, followed by mid-caps, small- caps, and micro-caps.

As we end the annual reconstitution, global markets have observed increasing levels of US small-cap market volatility and growing volume in derivatives linked to the Russell 2000.

Amid these historical swings, investors have been utilizing the small-cap futures market at record levels, seeking vehicles to enhance portfolio performance and manage market risk. Since the start of the year, we have seen notable increases in volume on Russell 2000 Index-based futures (RTY) as market participants have used our markets to manage small-cap equity market price risk amid significant levels of volatility and continued uncertainty.

For example, average daily volume (ADV) for E-mini Russell 2000 futures have risen by over 53% so far in 2020 versus the first six months of 2019. ADV for June exceeds 277,000 contracts. Average daily open interest in June currently stands at over 575,000 contracts; the highest daily average since August 2018.

Exhibit 2: E-mini Russell 2000 Index futures – average daily trading volume and month-end open interest

Source: CME group

The rebalance is a significant driver 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 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.

E-mini Russell 2000 Index (RTY) futures 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. Provisions for exchange-for-physical (EFP) transactions, block trading, Basis Trade at Index Close (BTIC) and Trade at Cash Open (TACO) transactions ensure that multiple avenues are open to contract users for position entry and exit.

In addition to allowing market participants to hedge macro exposures or anticipated directional movements in the Russell 2000 Index, RTY futures 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 purchase of RTY futures and sale of an equivalently sized number of CME E-mini S&P 500 Index (ES) futures contracts. The CME Clearing margin spread credit is 80% (June 2020) for a position scaled to 2 RTY long (short) versus 1 ES short (long).4

RTY futures likewise can furnish users with a means to take advantage of intra-market price discrepancies. A trader can enter a calendar spread, for example, by buying September RTY contracts and selling an equivalent exposure in December RTY contracts, if an opportune price discrepancy emerges between the two delivery months.5

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.

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, the Russell 1000 Total Return Index futures, the E-mini Russell 2000 Index (RTY) futures, or the Russell 2000 Total Return Index futures  respectively, to manage equitization of those cash flows. This may help avoid the need to trade cash index baskets with potentially volatile prices.

The annual reconstitution is one of the most significant drivers of short-term shifts in supply and demand for US equities. The use of Russell Index futures can help to mitigate risk for investors tracking the Russell 1000 or 2000 Index and aid investors who are seeking to benefit from price movements of relevant US equities.

Sources

  1. https://www.ftserussell.com/press/ftse-russell-begins-32nd-annual-russell-us-indexes-reconstitution
  2. https://content.ftserussell.com/sites/default/files/russell_us_indexes_recon_2020_recap_6.26.2020.pdf
  3. https://www.ftserussell.com/blogs/2020-russell-recon-big-getting-bigger-and-small-getting-smaller
  4. 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
  5. 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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