Stocks quoted in this article:
I want to take another break from our recent obsession with the lack of volatility to bring you one possible driver of volatility.
This Friday marks the long-awaited Russell Reconstitution! This, from Ron Bundy on the Russell Investments Blog -- not to be confused with Russell Rhoads' blog on the Chicago Board Options Exchange (CBOE) -- which led me here:
On the last Friday of every June, the contents of the Russell equity indexes are rebalanced. Essentially we hit a rather extensive "refresh" button, and a process known as reconstitution results in a market-driven rebalancing of all our global indexes. After a lot of mathematics and adjustments, the indexes are recast for another 12 months of market measurement and strategy.
Why does this matter to us? For one:
… the impact and scope of these changes extend far beyond our index lab. As of December, 2013, this annual event impacts more than $5.2 trillion in assets benchmarked to the Russell Indexes and nearly $800 billion invested directly in products based on the Russell Indexes. It's a recalibration process that is important to a huge percentage of retail and institutional investors. Consider that 73% of all U.S. institutional equity products are benchmarked to Russell Indexes, over $120 billion in ETF assets are benchmarked to Russell Indexes and nine of the 10 most-used U.S. equity benchmarks for institutional assets are from Russell.
And for another, it can potentially lead to some volatility in the impacted names.
Unlike the Dow Jones Industrial Average (DJI), the PowerShares QQQ Trust (QQQ), and S&P 500 Index (SPX), the Russell 2000 Index (RUT) uses a strict methodology to reallocate. The 3,000 largest-cap names make the index. The top 1,000 go into the Russell 1000 Index (RUI) … which nobody follows. The next 2000 go into the RUT, which the entire financial world follows. It's the de facto proxy for small-stock performance. Thus, if a stock moves into the 2000, index trackers need to own it. And if it's moving out in either direction, the trackers don't need it anymore.
So, that theoretically causes volatility in the affected names, which you can find here, by the way.
The unfortunate byproduct of fixed methodology is that anyone with interest in this has known basically which names were coming and going well before the list was made official last Friday. I'm sure tracking methodology varies, but it's pretty clearly underway already.
Having said that, it opens up the players to some risk. What if you buy a name that's going into the RUT and it tanks? Or sell one that's leaving and it flies? You'll lose a little contact with the index. Thus, there's still a lot of allocation yet to happen, and that opens the door for a blip of volatility.
It also opens the door for contra players. Many swear by going long names after they get bumped from a popular index and/or shorting recent adds. The theory is that all this reallocation causes artificial pricing that will then gradually mean-revert in the month or two after the reallocation.
If you're so inclined, there's a long list of names to check out on the Russell site.
Disclaimer: Mr. Warner's opinions expressed above do not necessarily represent the views of Schaeffer's Investment Research.