Investors used derivatives based on the Russell indexes more than ever in adjusting their portfolios to the 2003 reconstitution of the indexes. They did so because the growing number of derivative instruments based on the indexes provided them with more tools with which to control their risks and lower their costs. As a result, they appear ready to use them even more in the future. These tools, combined with other improvements in techniques for managing the transition to the new index, will lead to better results for investors and more efficient capital markets. This paper looks at the strategies that investors have used or considered using in managing the reconstitution process.
'Unlike other economic systems, the capitalist system is geared to incessant change …'
Joseph Schumpeter, "Capitalism, Socialism and Democracy"
The Russell indexes strive to accurately represent what is going on in the U.S. equity marketplace as a whole and within particular subsets of the overall market. Because the nature of companies that exist in a capitalist system is ever changing, as Schumpeter notes, companies come and go, and the indexes need to be reconstituted periodically to maintain their representativeness. Russell has chosen to reconstitute annually, after studying the balance between representativeness and turnover. Russell studies of reconstitution show that more frequent reconstitution increases turnover costs without sufficient improvement in representing the market.
Some index providers have gone to a 'banding' process that reduces turnover at the cost of being less representative and more opaque. A reason Russell's reconstitution has been much studied and is well understood is Russell's objective and transparent set of rules for determining membership. Indeed, many market participants argue that Russell's rules allow those who provide and seek liquidity to find one another more easily. The result is less market disruption than is caused by sporadic surprise announcements of changes.
During the process of changing index membership for any index, much attention is paid to the investors who manage index funds based on the relevant indexes. Russell surveys the passive management community once every six months about their assets under management in the Russell indexes. Below are the results of this survey for June 30, 2003.
|Russell Index Fund Assets|
|Index||Assets in Billions|
|Russell 3000 ®||
|Russell 1000 ®||
|Russell 1000 Value ®||
|Russell 2000 ®||
|Russell 1000 Growth ®||
This survey may not include all such assets. In particular, we are not sure that we have identified all of the internally managed Russell index funds. However, many investors find it useful to look at these numbers to analyze the size of the trades that are likely to take place over the reconstitution process.
Assets following a Russell 3000 mandate do not have a significant issue with the reconstitution since the turnover is lower than any of the other Russell indexes or the S&P 500. The reason is that the turnover in this index is primarily due to mergers and acquisitions (M&A) activity and stocks coming and going from the index at the lower capitalization (and therefore lower weighting) levels.
The Russell index with the second largest amount of assets in index funds, with more than $60 billion, is the Russell 1000. Since the Russell 1000 is simply the largest 1000 companies in the U.S., its turnover is relatively low as well. Once again, the turnover is from M&A activity and smaller companies that have grown large enough to join the index. In some years the turnover in the Russell 1000 is lower than the S&P 500; in other years it's greater. Since the M&A activity turnover is spread out over the course of a year, the turnover at the time of reconstitution of the Russell 1000 is generally fairly low.
The three indexes with the next largest amount of passive assets are the Russell 1000 Value, Russell 1000 Growth and Russell 2000. These three indexes have higher turnover than the broad and large-cap indexes, and therefore merit more discussion.
Russell Style Indexes
The Russell 1000 Value and Russell 1000 Growth indexes together make up the Russell 1000. The turnover of these indexes results from several factors embedded in Schumpeter's analysis. Over time, companies and markets change. Some companies grow and others shrink, so there is movement between the Russell 1000 and the Russell 2000. Some companies develop new products and innovations and, as a result, are viewed by the market as growth companies. Some companies have more limited sources of profit and revenue growth and come to be viewed by the market as value stocks as their stock prices decline relative to their balance sheets. Thus, the market view of companies moves between value and growth and between small and large. Since the Russell 1000 Value index funds have about twice as many assets as the Russell 1000 Growth index funds there is some crossing of assets between these index funds, but not all of the trades can be conducted as crosses.
The active assets benchmarked to the Russell 1000 Value and Growth indexes have been growing significantly over the past few years. About $400 billion is now benchmarked to these two indexes. It is unclear if the investment strategies of these managers collectively have an impact on the reconstitution trade. They are certainly less tied to trading on the day of reconstitution itself.
Further, the stocks entering and leaving the Russell 1000 style indexes generally are liquid securities and the market impact of conducting trades is fairly manageable. This level of liquidity is a reason the reconstitution of the Russell 1000 style indexes does not receive as much attention.
Passive funds tracking the Russell 2000 index receive the largest amount of attention in terms of words written and analysis done. Since the Russell 2000 makes up only 8% of the Russell 3000, the amount of assets in Russell 2000 index funds is larger in proportion to their capitalization than the combined assets of the Russell 1000 and Russell 1000 Value and Growth index funds. A fair amount of crossing occurs between the Russell 2000 funds and the funds benchmarked to the Russell 1000 family. If the amount of assets in Russell 1000 index funds grows relative to the amount in Russell 2000 funds, the issue of turnover in the Russell 2000 will decline. However, at this point, a significant amount of trading in the Russell 2000 continues to be conducted to reflect the changes in the small-cap market and, therefore, the index.
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.
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.
Russell Reconstitution As A Transition Trade
The Russell reconstitution can be viewed as a large transition trade. Transition trades now often involve the use of futures in managing the market risk level of the trade as it progresses. Many of the trading strategies discussed above are viewed in this way. Hedging one's market risk during a transition trade is growing more and more sophisticated and requires the use of more precise instruments than in the past. Using S&P 500 futures to hedge small-cap portfolio transitions introduces a level of basis risk that makes more sophisticated investors uncomfortable. The brokerage firms discussed above are engaged in a long-term transition trade and may want to use more precise instruments in their process of conducting that trade.
The growing acceptance of the Russell indexes as investment vehicles has caused market participants to improve their techniques for managing the transition from the 'old' index to the 'new' index. The growing number of derivative instruments based on the Russell indexes has provided market participants with more and more tools with which to control their risks and lower their costs. These improvements will lead to better results for investors and more efficient capital markets.
Frank Russell Company, a Washington, USA corporation, operates through subsidiaries worldwide, and is a subsidiary of The Northwestern Mutual Life Insurance Company. Frank Russell Company is the owner of the trademarks, service marks, and copyrights related to its indexes. Indexes and/or benchmarks are unmanaged and cannot be invested in directly. Returns represent past performance, are not a guarantee of future performance, and are not indicative of any specific investment. Russell 1000® Index: Measures the performance of the 1,000 largest companies in the Russell 3000® Index, representative of the U.S. large capitalization securities market. Russell 1000® Growth Index: Measures the performance of those Russell 1000® Index securities with higher price-to-book ratios and higher forecasted growth values, representative of U.S. securities exhibiting growth characteristics. Russell 1000® Value Index: Measures the performance of those Russell 1000® Index securities with lower price-tobook ratios and lower forecasted growth values, representative of U.S. securities exhibiting value characteristics.