Another alternative is to exchange one's position in an index fund into the relevant ETF. In the case of the Russell 2000, that is the iShares Russell 2000 (IWM). Making this trade in the second quarter and reversing it in the third quarter transfers the responsibility of managing the reconstitution to the manager of the ETF. This strategy does not mitigate the effects of the reconstitution quite as much as the synthetic index fund, but it does take the issue out of the hands of the portfolio manager.
Now that there are single stock futures and, therefore, futures on ETFs, one can create a synthetic index fund using futures on ETFs. Several features of futures on ETFs make them interesting tools for this application. First, the expirations occur monthly, so that basis risk can be controlled around the reconstitution more finely than with futures expiring quarterly. Second, the delivery vehicle is the ETF itself, so if one holds a position to expiration one either delivers or takes delivery of an ETF. In addition, the exchanges allow for exchange-for-physicals trades. Thus, if two participants agree that a portfolio is close enough to the ETF, the portfolio can be traded for cash plus the future on the ETF.
With these features, during the second quarter an investor can trade an existing portfolio of 'old' stocks for cash plus July ETF futures. In July, the investor has the choice of reversing the exchange for physicals or taking delivery of the 'new' ETF. Interestingly, the amount of futures on ETFs that can exist in open interest is unlimited, so in theory this strategy could hold all of the indexed investors in the market.
Russell Derivatives Strategies: Liquidity Providers
Some brokerage firms wish to hold inventories of stock that are about to be added to an index-for example, the Russell 2000. These firms can hedge their positions against broad moves in the market by shorting either Russell 2000 or IWM futures. This ability to hedge allows brokerage firms to amass more inventory to accommodate either side of the reconstitution. It is particularly useful that the futures have significantly lower transactions costs than the underlying securities.
Of course, those willing to take on more risk might hedge with put options rather than futures. The primary point here is that firms have a variety of tools to manage and control their risk. Use of these tools can significantly reduce the costs for the brokerage firm. Competition will reduce these costs for investors as well.
Hedge funds have turned out to be significant liquidity providers for the reconstitution trade. Some hedge funds develop opinions about particular securities or groups of securities. Sometimes the opinions are related to these securities either outperforming or underperforming a particular index as opposed to an overall market view. Derivatives provide an opportunity to put on a position to take that risk. So, for example, if someone believes the stocks being added to the Russell 2000 are going to outperform the Russell 2000, one can buy the stocks of the companies being added and sell short the appropriate amount of Russell 2000 futures. This hedges the investor against an overall fall in the small-cap market and still allows that investor to make money if the bet is correct. Of course, one could also hedge the position by buying puts on the index or the ETF.