Approach the Russell Reconstitution With Caution

 | Jun 19, 2013 | 11:30 AM EDT  | Comments
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This piece originally appeared on Options Profits on Wednesday, June 19, at 8:27 a.m. Eastern time. It's a special feature from the Chicago Board Options Exchange Institute, written by Russell Rhoads, CFA. He is a financial author and editor, having contributed to multiple magazines and edited several books for Wiley publishing. In 2008 he wrote Candlestick Charting for Dummies, and he is the author of Option Spread Trading: A Comprehensive Guide to Strategies and Tactics. Russell also wrote Trading VIX Derivatives: Trading and Hedging Strategies using VIX Futures, Options and Exchange-Traded Notes. In addition to his duties for the CBOE, he instructs a graduate level options course at the University of Illinois - Chicago and acts as an instructor for the Options Industry Council.

June is usually a quiet time in the markets. Summer is beginning, second-quarter earnings are on the horizon, and the markets are expected to be calm. One thing that happens each year in June that catches the attention of some market watchers and traders is the rebalancing of the Russell indices.

Unlike other market benchmarks, additions and deletions to the Russell indices are made according to a schedule. At the end of each quarter, newly public companies (IPOs) that qualify will be added to Russell indices. The big rebalances come at the end of June each year with a more extensive overhaul of these indices. The alteration made to most of these indices is based on changes in market capitalization. This is commonly known as the Russell Reconstitution.

The process actually starts on the last trading day of May, when the market capitalization of all public companies in the U.S. is locked in for the Russell Reconstitution process. The first announcement regarding the additions and deletions from the indices occurs in the middle of June. This list came out on June 14, with the result being the 3,000 largest public companies in the U.S. as of May 31, representing the new membership in the Russell 3000. The Russell 1000 will consist of the 1,000 largest of these companies and then widely followed Russell 2000 will consist of the bottom 2,000 stocks in the Russell 3000. A small tweaking of the list may come out this coming Friday with the final list and weightings of the components released on June 28. On July 1, the Russell 1000, Russell 2000, Russell 3000 and countless other indices will be calculated and quoted on the basis of new constituents and weightings.

For U.S. traders, the constituent changes may have a short-term impact on certain stocks. Do keep in mind that many hedge funds and other short-term traders will try to get long stocks that may trade higher or short stocks that may trade lower based on the reconstitution. Also keep in mind that the market prices that dictate the index changes were known by these short-term traders for some time. They have had a bit of time to formulate their trading strategies around funds that may need to rebalance to match the performance of one of the Russell indices.

There have been a couple of interesting observations about pending changes. First, Apple (AAPL) is going to see a reduction in its allocation to the index due to the lackluster performance of the stock. Between May 2012 and May 2013, Apple was down about 22%. Apple is still the largest stock in the index, but will make up a smaller portion of a portfolio, replicating the Russell 3000 or Russell 1000.

Another stock that is getting some attention around this process is Facebook (FB). Facebook was added to the Russell 1000 and Russell 3000 last year after the company's initial public offering in May 2012. At the time, the market capitalization of the shares outstanding was about $10 billion. As Facebook has gone through lockup periods where more shares are now available for trading, the capitalization of shares available for trading is over $40 billion. That means the number of shares that need to be owned by index funds should see a large increase.

The news regarding the Russell Reconstitution process will continue to flow over the next couple of weeks, but again a note of caution. There are always traders who hear about the reduction of Apple or the addition of Facebook to portfolios and think they can benefit from these changes. Keep in mind that some traders have been trading this process for years and have been analyzing this year's changes for weeks. A little caution may be in order before trying to jump in front of the Russell Reconstitution process.

For more information on the Russell Reconstitution process, please go here.

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