Russell rejiggers index benchmarks

The annual ritual involving “passive” fund managers rejiggering the composition of their index funds is likely to cause one of the heaviest days of trading this year Friday, but if things go according to plan, advisers who use index funds and investors in those funds won't notice a thing. Russell Indexes will rebalance its benchmarks — including the popular small-company Russell 2000 — after financial markets close Friday in an effort to maintain the character of the indexes as small companies, for instance, become too large to really be considered “small-cap” or as “growth” stocks start to look more like “value” stocks. Indeed, one result of the bull-market is that small capitalization is looking a lot less small. The cutoff, or breakpoint, between large and small-cap stocks in Russell indexes, is increasing 19% to $3.1 billion this year, according to the company. “Over the last several years with appreciation you've seen market caps really drift higher,” said Steven G. DeSanctis, small-cap strategist for Bank of America Merrill Lynch. “People have to change their definitions of small and mid at this point.” There are several other changes. Business development companies are no longer eligible for inclusion in the indexes alongside stocks, which will affect the composition of funds tracking those benchmarks. So too will the reclassification of Egypt from an emerging to a frontier market. And a number of stocks will be moved to different categories. Because Russell Indexes has announced the changes well in advance of the actual index reconstitution, the trading by fund managers to align their portfolios with the rebalanced indexes already has been underway, but Friday is the last day they have to make changes as the “new” indexes will start being calculated on Monday. Thus, Credit Suisse traders expect $42 billion in securities to change hands Friday as a result of the rebalance. “All of the stocks that are in that trade are relatively small and relatively illiquid, so it's multiple days of volume that has to be found in the market,” said Phil Mackintosh, head of trading strategy and analysis at KCG Holdings Inc. “It tends to all go through or almost all go through market-on-close.” Fund companies say they work to execute trades so they won't be taken advantage of by market participants who expect large amounts of money to move at the same time, into or out of the same stocks. Most companies are reluctant to offer specifics on their trading strategy. But Joel M. Dickson, senior investment strategist at The Vanguard Group, says managers face a delicate balance between managing a fund around the reconstitution to achieve maximum returns or to minimize deviations from the benchmark, which many exchange-traded fund investors are keen to monitor using statistics like tracking error and tracking difference. According to Mr. Mackintosh, whose firm trades with and on behalf of fund managers, being on the other side of trades involving index funds comes with its own risk. That means there's no guarantee they'll get the best of fund managers who need to trade. “People that are involved in facilitating this index flow are definitely taking on market risk and the amount of market risk compared to the return the last few years has not been that great,” Mr. Mackintosh said. Active fund managers have more flexibility in choosing whether to honor the changes and when to execute trades, according to market participants. Russell says it works to make the job of those market participants easier with a transparent, rules-based process in which many of the changes are announced well in advance of the trades, according to Rolf Agather, managing director of global index research and innovation for Russell. More than $5 trillion in assets are benchmarked to Russell's U.S. indexes in total. That was among the factors cited by the London Stock Exchange Group Thursday when it announced plans to acquire Russell Investments in a $2.7 billion deal with the Northwestern Mutual Life Insurance Co. The deal creates the second-largest index provider of U.S.-listed exchange-traded funds by combining Russell Indexes and FTSE. The firm also has a prominent investment consulting and asset management business.