Russell Reconstitution And Derivatives

February 12, 2004

Most of the dollar turnover in the Russell 2000 results from stocks moving between the Russell 1000 and the Russell 2000 because these stocks are the largest stocks in the small-cap index. For example, Dell, Oracle and Schwab were once small-cap stocks and joined the Russell 2000 more than 15 years ago. Over time, Dell, Oracle and Schwab have matured into largecap securities and now rank among the 200 largest U.S. companies (in terms of market capitalization) and need to be part of any representative large-cap index.

Liquidity providers and liquidity seekers spend much time positioning their portfolios both before and after the June reconstitution. Over time, the strategies investors have used for this positioning have grown increasingly sophisticated.

One way investors hedge their positions is through the use of derivatives. 


Russell Index Derivatives

Exchanges have increased their offerings of derivatives based on the Russell indexes over the past few years. A wide variety of derivatives with varying liquidity are now available. The chart below shows the derivatives available for the indexes most affected by the Russell reconstitution.

Reconstitution Derivative Strategies: Index Matchers

Those investors who want to avoid participating directly in the Russell reconstitution trade have alternatives; one involves the use of a synthetic index fund. Using an exchangefor- physicals trade in the second quarter, an investor holding a Russell 2000 index fund with the 'old' set of stocks can exchange that position for cash and Russell 2000 futures expiring in September. During the third quarter, the investor can reverse this trade by accepting a portfolio of the 'new' stocks in exchange for cash and the Russell 2000 futures position.

This strategy does not require the index fund to trade on the last day of June. The investors on the other side of this trade would generally be brokerage firms who also would not be required to trade on reconstitution day. Taken to the extreme, if all Russell 2000 index fund investors engaged in this strategy, the turmoil in June would be reduced, if not eliminated. But practical issues, such as some portfolios being prohibited from using futures, may prevent investors from using this strategy.

Russell 2000 index holders can and do build up cash in the second quarter, and equitize that cash with Russell 2000 futures. Given the low transaction costs of Russell 2000 futures versus the underlying stocks, this strategy can work especially effectively with the natural cash flows into and out of the fund.

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