Indrani De
Catherine Yoshimoto
- The Russell indexes are transparent and predictable in their design and changes, which reduces the chances for arbitrage by hedge fund traders.
- The Russell indexes follow three principles of objectivity, modularity and reliability, which makes them market-leading benchmarks.
- The Russell indexes have undergone enhancements over the years to meet the demands of professional investors, helping balance market representation with effectiveness.
Accuracy and predictability are key in equity index design.
When index funds and index-tracking exchange-traded fund (ETFs) first became popular, some enterprising hedge fund traders decided they could make money by anticipating and exploiting index additions and deletions.
In a capitalisation-weighted index, some turnover is inevitable. Over time, companies with rising share prices grow and join the index. Other, less successful companies drop out.
These changes occur on a schedule, set out in the index rules, that’s transparent and predictable.
So all the hedge fund trader had to do, in theory, was to work out which stocks were joining an index and which were leaving, and buy (or sell) them in advance of the date on which the index changes were taking place.
After all, on that ‘effective’ date, billions of dollars in index fund and ETF assets would be reshuffled from one set of stocks to another. Surely that created an opportunity for relatively risk-free arbitrage?
There is evidence that this kind of trade made money in the past, for example in the 1980s and 1990s.
But in a recent paper[1], Robin Greenwood and Marco Sammon of Harvard Business School say this so-called “index effect” has been disappearing.
This is because there is “increasing liquidity around index change events”, say Greenwood and Sammon.
“Over the past 15 years, Wall Street trading desks have increased personnel and computing resources devoted to index trading, with several large players having specialized sell-side teams. Large passive investors also employ large teams to study and improve liquidity around rebalancing,” the researchers say.
So although the annual reconstitution of the Russell US indexes is now one of the most active days in the US stock market calendar—it regularly generates over $100bn of trading volume—it tends to happen on the fourth Friday of each June without much fanfare.
US market trading volumes at the close of Russell reconstitution effective day in June
| US$ billions | 2017 | 2018 | 2019 | 2020 | 2021 | 2022 |
|---|---|---|---|---|---|---|
| $ traded across Nasdaq and NYSE | 76.0 | 97.7 | 107.5 | 126.6 | 186.0 | 143.1 |
Source: FTSE Russell, NYSE, and Nasdaq, as of June 24, 2022.
From FTSE Russell’s point of view, and from that of most of our clients, this lack of drama is just what you want to see in an equity index.
Objectivity, a modular construction approach and reliable maintenance and governance are the three principles we believe a market-leading benchmark should follow[2].
Predictability in an index’s design doesn’t mean its rules are set in stone. Over the years, we’ve added enhancements to make sure the Russell indexes balance market representation with effectiveness.
For example, in 1984 we were the first index firm to adjust share totals for free float. This ensured that only the investable portion of index constituents’ market capitalisation was included in the index.
In 2004, we began adding eligible initial public offerings (IPOs) quarterly to reduce the impact at the annual reconstitution. We adjust the Russell indexes daily to reflect corporate actions like share splits, mergers, buy-backs and dividends.
In 2007, we introduced “banding” around the index breakpoint between the Russell 1000 and Russell 2000 indexes, helping reduce index turnover. In 2017, we set a minimum 5% company voting rights hurdle to help improve index investability.
And in late 2023 we asked clients for feedback on whether we should switch the annual Russell index reconstitution to a semi-annual event, with the objective of keeping market disturbances to a minimum. The results of this consultation will be published in 2024.
These details probably won’t make the financial news headlines. But they add up to a no-surprises approach that makes the Russell indexes the preferred US equity benchmarks for many professional investors.
1. ‘The disappearing index effect’, Harvard Business School working paper 23-025
2. See FTSE Russell | Building a Better Benchmark: A Practical Guide (lseg.com)
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