"Beating the index" is a common goal of individual investors and fund managers alike -- but that begs the question: Which index are they all trying to beat? The answer to that question is the reason why June 25 will be an extremely volatile trading day.
On Friday, after the market closes, the Russell Investment Group will announce how it will rebalance its indexes in the annual event known as the Russell Reconstitution. All of its indexes will see changes in the baskets of stocks they include.
While this may not sound like a significant event, historically, the response of the markets to it has proven otherwise. According to calculations by Anne Price of NYSE Euronext, the volume of trades spikes considerably on the day of the Russell Rebalance. Compared to an average daily volume of 1.4 billion shares traded on the New York Stock Exchange, reconstitution day in 2009 saw a staggering 2.35 billion shares traded.
Why Is This Day So Important?
Because so many funds either tie themselves to or measure their performance against the broad Russell indexes, knowing what stocks will be in those indexes make a huge difference. Many funds designed to track a specific index are obligated to hold only stocks in that index -- for example, a fund that is designed to mimic the Russell 1000 might be restricted to holding only Russell 1000 stocks. Thus, when stocks are dropped from or added to an index, fund managers have to respond accordingly.
Benchmarked funds, whose gains and losses are judged against a certain index, commonly hold many of the stocks that are included in their benchmarked index. What better way to insure a performance close to that of the Russell 2000, for example, than to include a lot of Russell 2000 stocks? Again, the result of this game of follow the leader is that when a commonly-used index changes its makeup, fund managers must respond.
In the case of the Russell Indexes, the effects are amplified because they are especially popular benchmarks. Russell Investments estimates that $3.9 trillion of institutional investor money is benchmarked to an index, and that Russell's own indexes are the most widely used benchmarks.
The Effect on Investors
This heavy trading that institutions will have to engage in creates an interesting scenario for investors. When a company's stock is added to an index, demand can see a sizable jump as managers move to add it to their portfolio. Naturally, all that action can rapidly increase a stock's price, and investors who can anticipate such jolts can achieve a substantial return.
However, such anticipation has been going on for months by an enormous number of speculators. It would be exceptionally difficult to find a company that was set to be added that other investors had overlooked. Only in this scenario would someone be able to profit significantly from the Russell Reconstitution, and only through blind luck would it be possible.
Hunting for a Rare Opportunity
Nonetheless, even though the possibility for profit is minuscule, speculators continue to look for opportunities. This will only add to the volatility that is to be expected on Russell Rebalance day, even though the official rebalance will not happen until after the market closes.
Institutional investors, speculators, and traders of every kind will be particularly active, and the day may prove to be a dangerous one. Anticipating the index is just as risky as trying to beat it, and even investors who aren't trying to do so should be extra wary on this particular day.
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