Russell Rebalance Will Boot Top Health Stocks

NEW YORK (Reuters) – The Russell 2000 index of small company stocks will lose some heavy hitters from the health-care sector when FTSE Russell rebalances its indexes starting Friday, depriving the index of companies that provided much of its growth this year.

Rebalancing the Russell 2000 and the Russell 1000 happens once a year, mainly on the basis of changes in market capitalization. As companies move from one index to another, managers of index-following funds are forced to buy or sell shares so as to mimic the performance of the index.

That means they'll have to sell some health-care shares, just as those shares hover near their peaks. Anywhere between 25 to 40 stocks have become too big for the Russell 2000, and will move to the large cap Russell 1000, analysts said. About 10 of those will be from the health-care industry, the largest shift of any sector.

Growing Market Caps

Stocks in the sector that are expected to be promoted to the larger cap index include Isis Pharmaceuticals, up about 86 percent since the last rebalance; Puma Biotechnology, up more than 105 percent over the same time frame; Intrexon, up 101.3 percent; and Bluebird Bio, up 334 percent.

At the same time, about 40 other health-care companies with market caps as low as $177 million will be added to the Russell 2000 index, forcing the index-mimicking managers to buy the shares. Those companies include Advaxis, Neogenomics, Aduro Bioech and XBiotech.

Through the close on June 18, the Russell 2000 had risen 7.92 percent on a total return basis, with 4.76 percentage points, or about 60 percent of the total advance in the index, coming from health-care companies, according to ETF.com data since the rebalance in the prior year by Russell on June 27.

About $45 billion in index fund assets track the Russell 2000 index, slightly more than double the $22.1 billion invested in Russell 1000-tracking index funds, according to Morningstar. The automatic selling of health-care shares could protect investors in Russell 2000-tracking funds by locking in some of their profits while the sector is riding high, though it could also force them to leave some future earnings on the table.

Less ‘Healthy’ Constituents

As a result of the strength among biotechs within health care, Bank of America Merrill Lynch has recommended investors be selective in the group as gains may be harder to come. Health-care stocks constituted 16.4 percent of the Russell 2000 on June 12, just before Russell announced a preliminary list of additions and deletions. After the reweighting at the end of the month, health care will be 15.5 percent of the index, Bank of America Merrill Lynch said, based on the preliminary announcement.

"Health-care stocks have been really strong performers and their market cap is going to be above the $4.3 billion or so cut off point" for the Russell 2000 index, said Steve DeSanctis, small cap strategist at Bank of America Merrill Lynch in New York. Basically, the index "is getting rid of a few big ones and getting a bunch of smaller ones being added."

M&As Key To Performance

Funds following the Russell 2000 index will sell those health-care companies as soon as the final rebalancing is announced at the end of June; some active managers have already made trades in advance of the Russell announcement.

Health-care companies have seen $260 billion in merger and acquisition activity over the last year, the second biggest M&A sector behind energy at $265 billion, according to Thomson Reuters data. Should that activity begin to slow, it could signal a component behind the fast growth of small cap health care names is starting to dwindle just as they move out of the Russell 2000.

Investors in the larger cap funds could see their weighting of health-care stocks inch up from 14.6 percent to 14.8 percent, according to BofA/Merrill.

"Those forty names coming into the Russell 2000, those are the ones that are more likely to show the dynamic growth - or the dynamic failure," said Chad Dale, director of Index Research at ITG in Toronto.