The Russell Reconstitution Effect

Significant returns were associated with the annual reconstitution of the Russell equity indexes from 1996 through 2002, which can be explained by both transitory price pressure and the permanent effects of index membership. On the one hand, the return effects represent a significant cost to index funds that rebalance on the reconstitution date. On the other hand, supplying immediacy at this time can be highly profitable. This strategy is typically undiversified, however, and involves high trading costs and price risk as positions are unwound. Indeed, dramatic intraday return volatility characterizes the day of reconstitution. These factors explain the persistence of the reconstitution effects documented here. Periodic index rebalancing is associated with substantial price movements for the stocks added to and deleted from the index. These price changes can significantly affect index managers who rebalance their portfolios on or around the reconstitution date and even traders and portfolio managers with other performance benchmarks who closely follow the reconstitution of widely followed indexes to anticipate buying and selling pressure on securities they plan to trade, as do certain hedge funds. In general, reconstitution effects raise questions about the nature of passive indexing, index construction, and market efficiency. This article examines the annual reconstitution in 1996–2002 of the equity indexes of the Frank Russell Company, which reconstitutes its indexes at the end of June each year on the basis of company market capitalizations at the end of May. The reconstitution of the Russell equity indexes is of particular interest for several reasons. First, the Russell indexes are widely used as performance benchmarks. Second, abnormal returns and volumes accompany the annual reconstitution of the Russell indexes as managers rebalance their portfolios; the effects are significant and pervasive and affect a large number of stocks simultaneously but have not previously been analyzed systematically. Finally, because the criterion for membership in the Russell indexes is based on market cap at the end of May, it can be readily computed in the month before the reconstitution. Consequently, the effects of reconstitution on returns provide valuable insights regarding market efficiency. I show that return effects associated with the Russell reconstitution are much larger in magnitude than the corresponding effects for S&P 500 Index revisions, which have been the focus of much previous research. Specifically, a portfolio (constructed after the determination of new index weights at the end of May) that was long additions to and short deletions from the Russell 3000 Index had a mean return of 14.94 percent in the month of June for the period 1996–2002. The difference in returns across stocks is explained by both permanent changes in liquidity associated with changes in index membership and by shorter-term price-pressure effects induced by fund flows. I confirmed these findings by decomposing returns around the reconstitution date. The findings I present have immediate practical implications. In particular, the return effects represent large hidden transaction costs for investment managers who rebalance portfolios on a reconstitution date to match index revisions. The findings suggest that investment managers can obtain higher realized or net returns by trading ahead of the reconstitution or achieving their desired exposures through swaps or derivatives. A passive fund that does not immediately rebalance to match changes in the benchmark can use passive trading strategies to reduce trading costs, albeit at the risk of increased tracking error. Such a trading strategy can have a high Sharpe ratio. These considerations might also drive the creation of new funds benchmarked to nondisclosed indexes or methods of index construction or revision that are different from those currently in use. Conversely, the results indicate that a strategy of trading on projected index revisions can be profitable. Because of the transparency of the reconstitution process, forecasts of the upcoming June index revision can be made at the end of May with a high degree of precision. Out-of-sample tests reported here indicate that these returns closely mimic the actual returns in June. Such a preemptive strategy can, however, be risky. One reason is that portfolios based on projected additions and deletions typically involve sectoral bets. In 2001, for example, the technology sector was heavily represented among the projected deletions and the financial services sector was prominent among projected additions. Also, when traders unwind their positions on or around the actual reconstitution date, they incur significant timing risk. Dramatic intraday price movements on the reconstitution date itself indicate the difficulty of anticipating excess demand from index funds whose positions may be large relative to the risk arbitrageurs on the opposite side. Liquidity is also paramount. The transaction costs associated with trading small-cap stocks are large, so scaling certain positions is difficult, and short positions in some stocks may simply be impossible. These considerations explain the persistence of index reconstitution effects in an efficient market.