Provisionally Speaking

January 01, 2006

Broad market index funds have existed for three decades now. Over the last decade, interest in specialty index funds such as growth, value and small-cap has grown strongly. This phenomenon is tied to the growing popularity of Russell's family of indexes and Russell's index philosophy.

When Russell designed its index family, it aimed at providing a set of benchmarks for most of the styles of active management available in the market. In the U.S., some active equity investment managers have specialized by style for decades. The Russell 1000 Value and Growth, the Russell 2000 and the Russell 2000 Value and Growth indexes were each designed with a particular group of managers in mind. The specialty indexes enable Russell to evaluate these managers against a relevant index rather than against a broad-market index such as the Russell 1000 or the Russell 3000. For example, a small-cap growth manager is evaluated against the Russell 2000 Growth index.

The stocks that are chosen for each specialty index are selected on the basis of the stock's characteristics; they are not drawn from a predetermined list. Small-cap managers once held Dell; however, it hardly fits that category any longer. Growth managers once held Pfizer; today this stock is held primarily by value managers. Therefore, by nature, the indexes that properly benchmark these active managers have higher turnover than the broad-market indexes.

In constructing portfolios of managers for our asset management business, Russell and many other investors mix active and passive management in a risk-managed way. If we can find active managers in a category who instill confidence in their abilities to select stocks, we include them in our portfolios. If we end up with an unbalanced portfolio of active managers by style, we can reduce our nonmarket risk by balancing the portfolio with specialty index funds.

As the sophistication of investing and investment tools has increased, the use of specialty indexes and specialty index funds has increased. Let us examine the impact of this explosion on the index fund management industry.

Evolution Of Index Fund Management

When index funds first began, there were few assets invested in them. Most of the assets that were invested were in large-capitalization U.S. equity stock indexes with relatively low turnover. Index fund managers had to convince investors that indexing was an appropriate way to manage money.

As they succeeded in doing so, the number of index fund managers grew, as did the amount of assets being passively managed. Index fund managers had to compete with each other as well as against the active management community. Investors fell into the habit of using tracking error and price to evaluate index fund managers. While these measures are convenient and simple, as the industry has evolved, they have become less appropriate.

In addition to assets, the number of indexes used as benchmarks for passive products has grown. Since many active managers specialize in particular portions of the market, and investors putting together multimanager portfolios want to control their risk relative to the overall market, these investors will often balance specialty active managers and passive investments.

With the higher turnover of specialty indexes, we should be looking for passive managers to minimize transaction costs, including the market impact on the portfolio. Index fund managers have been using a variety of techniques to accomplish this task. We discuss one of these techniques below.

Provisional And Legacy Returns For Russell Reconstitution

A big event in the year of many passive managers is the annual Russell index reconstitution. To provide investors and investment managers with additional flexibility, in 2005, Russell began publishing provisional and legacy returns for our indexes during June and July. The providing of both provisional and legacy returns provides the investor with greater control over when they wish to implement the reconstitution of their own portfolios. Prior to 2005, it was difficult for investors to hold index fund managers accountable for transitioning on days other than the official date. Russell's innovation was designed to lower costs and give managers the flexibility to transition their portfolios on other days over an almost two-month window.

A provisional return is the return to the "new index" before it becomes the official index. A legacy return is the return to the "old index" after it is no longer the official index. We have provided these returns through the returns calculator on www.russell.com, as well as in the data set provided to all index fund managers. Using the provisional and legacy returns, one can easily put together a custom index assuming a transition date of any day in June or July. We calculated the two-month total rate of return for each of the Russell indexes for each of the possible transition dates. Figure 1 shows the range of returns for each of several Russell indexes over the various potential transition dates in 2005.

The range of returns was small for Russell's broad-market (Russell 3000) and large-cap (Russell 1000) indexes. But for the specialized style and small-cap indexes, the spread in returns was more significant.

For most of the indexes, the actual reconstitution day (June 24) was neither the best nor the worst return. The exceptions were that June 24 proved to be the best day to transition a Russell 1000 Growth index fund, and also the worst day to transition a Russell 1000 Value index fund. Since most of the changes in these two indexes were the movements between them, and since their relative sizes are comparable, this inverse relationship seems likely, but this may not necessarily be repeated in future years.

Below we display the two-month returns using different transition dates for the Russell 2000. The vertical axis is the two-month rate of return. The horizontal axis represents the transition date used in calculating the return. The chart shows that in 2005 the spread of returns was wider for the Russell 2000 than for the broad market Russell 3000 or the large cap Russell 1000.

Investors who transitioned early in June or during July did better than those who transitioned in the second half of June, when the actual reconstitution date occurred. This chart indicates there is some risk in deviating from the actual reconstitution date for doing one's transition, but in 2005, most of the risk was on the upside.

Calculating Tracking Error Using Provisional And Legacy Returns

Investors in index funds might well be willing to consider having their managers use different transition dates for their portfolios, but they still want to have the accountability of calculating tracking error against the appropriate index. The availability of provisional and legacy returns from Russell allows the investor to easily put together a "custom" index assuming a transition date other than the official date using data available on www.russell.com. The investor can then calculate a tracking error relative to this custom index and evaluate the index fund manager using this measure.

Flexibility In Managing The Russell Reconstitution

Index fund managers, as a whole, have excellent trading capabilities. Investors should work with their managers to allow flexibility in managing the transition of portfolios through events such as the Russell reconstitution. This holds particularly for specialized indexes such as style or small-cap indexes. Given flexibility, managers can work to minimize transaction costs to the benefit of their clients.

Provisional and legacy returns allow investors to provide this flexibility to clients without doing away with the accountability of minimizing tracking error. The tracking error for June and July is calculated relative only to a customized index.

To date, some investors have traded earlier than the official reconstitution date. The data from 2005 indicate that investors should also consider transitioning their portfolios after the reconstitution date.

It is important to remember that the purpose of investing in specialty index funds is to gain exposure to a particular market segment at low fees, while controlling one's risk. In the case of specialty index funds, there can be a trade-off between tracking error against the official index on the one hand and transaction costs on the other. Index fund managers can help you manage those transaction costs.

Russell Investment Group is the owner of the trademarks, service marks and copyrights related to its respective indexes. Index funds are not sponsored, endorsed, sold or promoted by Russell Investment Group, and Russell Investment Group makes no representation regarding the advisability of investing in such funds. Investments in index products may not provide the exact performance of the indexes due to expenses and fees of the investment product.

* Please note that past performance is no predictor of future performance. The indexes are unmanaged. There are investment products based on the indexes.

 

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