Money managers wanting to "play" the Russell index rebalancing ahead of the June 30 shift will find such a move tougher than usual.
The reasons: market volatility and the sheer number of stocks coming and going from the 21 U.S. equity indexes.
"The volatility adds a different dynamic to the reconstitution," said Brad Pope, head of large-capitalization equity indexing at Barclays Global Investors, San Francisco. "It's going to make it difficult for investors to assess what's going to happen ahead of time."
But the changes in the indexes -- and how they affect the indexes' sector weightings and value and growth orientations -- also could have a major impact on active, as well as passive, managers.
The June 30 rebalancing of the 21 indexes, which comprise 3,000 stocks, is expected to be the biggest ever. The mostly widely used of the indexes are the Russell 1000 large-cap index and the Russell 2000 small-cap index.
While trading often occurs well in advance of the rebalancing, analysts believe trading activity may be delayed this year until the end of June because of the volatility in the market.
"This year, it will be a slightly larger trade, and also with the volatility in the market, perhaps a more volatile trade," said Robert Bergson, portfolio manager at Northern Trust Global Investments, Chicago. "Our goal is to minimize cost and impact of the trade."
Mr. Bergson manages the $262 million Northern Institutional Small Company Fund. The fund's management team has not yet determined when it will make its trades.
Typically, managers overweight their portfolios with stocks projected to move to the Russell 1000 from the Russell 2000 before the rebalancing, because those stocks tend to outperform before the event takes place.
This year, the reverse could happen, said Peter Jankovskis, principal and director of research at OakBrook Investments, Lisle, Ill. "There's going to be selling pressure because the total amount invested in these stocks is probably going to decline after they're moved into the Russell 1000."
So instead of buying stocks in front of the rebalancing, Mr. Jankovskis said, there might be active managers selling stocks.
The changes in the indexes also might change the rules for money managers and their institutional clients that are benchmark-sensitive. "It's going to change things, because the pond in which they fish will change," said Brad Lawson, senior research analyst at the Frank Russell Co., Tacoma, Wash. "Active managers are going to have to make a lot of choices."
The Russell indexes are expected to take on a dramatically different look as a result of the rebalancing.
"We expect the indexes themselves to become more volatile going forward just because the composition has changed," said Mr. Lawson.
That could affect managers of the more than $175 billion in index funds using the Russell indexes as a model. It also will affect the billions of dollars in actively managed funds that use the indexes as benchmarks.
More tech stocks
A report by Goldman Sachs & Co., New York, on the rebalancing said the Russell 1000 will become more heavily weighted in technology stocks, and the percentage of Internet stocks will be higher than in the Standard & Poor's 500 index.
On the other hand, the technology sector weighting in the Russell 2000 is expected to drop 8.9%, the report said. Subsequently, consumer discretionary and financial services will increase by 2.3% and 3.4%, respectively, in the Russell 2000.
Mr. Lawson said the strong performance of technology stocks and the flood of technology IPOs since last year's reconstitution will alter the face of the Russell 1000. He expects between 30% and 35% of the names to change in the Russell 2000 on June 30 and about 25% of the names in the Russell 1000 to change.
The chain of events that Mr. Lawson anticipates will see the Russell 1000 -- both the growth and value indexes -- become more growth-oriented.
The high-flying technology stocks likely will push some traditional non-technology growth stocks, such as consumer staples and health care, into the Russell 1000 Value index.
In turn, those stocks likely will push more traditional value names in areas such as financials into the Russell 2000. As a result, the Russell 2000 small-cap index could become more value-oriented. "Typically, we think of the Russell 2000 as a place where we find young, dynamic, rapidly growing companies," said Mr. Jankovskis. As a result of the likelihood of older, more established firms being displaced by the rebalancing, "We may temporarily see the Russell 2000 taking on a more stable appearance than it has in the past," he added.
When last year's reconstitution took place, the Russell 2000 Value index had 14.8% technology stocks. According to a preliminary rebalancing study by Russell, if the Russell 2000 Value index had been rebalanced on April 30, it would have been 10.2% technology stocks.
Sector surges
On the other hand, the Russell 1000 Growth index, which had 29.8% in technology June 30, would have had 43.5% technology had it been rebalanced April 30.
Mr. Lawson said he expects the technology segment of the Russell 1000 Growth index to be "north of 50%" when the rebalancing actually takes place. A preliminary list of additions and deletions will be posted by Russell on June 9.
These shifts also might change the rules for money managers and their benchmark-sensitive institutional clients.
On the value side, managers that track the indexes may have to start buying stocks that have not traditionally been considered value.
Growth managers will have to be concerned with volatility and risk because of the higher degree of technology stocks. "Do you hold an inherently more volatile portfolio of stocks in order to stay closer to the benchmark?" asked Mr. Lawson.
Evan Grace, vice president, equity quantitative research group at State Street Research & Management Co., Boston, sees another concern for active managers. With a more than 50% sector weighting in a widely accepted benchmark index like the Russell 1000 Growth, some managers might run up against sector weighting limits imposed by plan sponsors.
"You could have a situation where a manager is benchmarked to a particular index, and is forced to hold a meaningful underweight in relation to that index," said Mr. Grace.
From an active management standpoint, Mr. Grace said, the rebalancing will require many managers to adjust their sector weights to keep up with the changes.
"If your benchmark changes and you do not, that translates into an increase in tracking error, and benchmark risk," he said.
