Once again, US markets saw record volumes traded during this year’s Russell Index Reconstitution. This is the time of the year where FTSE/Russell reviews and rebalances their US family of indices to reflect market changes over the preceding twelve months.
For years, this event has been the most anticipated and heavily traded day of the year both for equity index managers along with many active and hedge fund managers. An estimated US$ 8.6 trillion1 in assets are benchmarked to Russell indices in total. That said, a substantial amount of money is in motion on or around the day of the Reconstitution leading to potential market dislocation and sizable price appreciation/ depreciation. While active managers have long sought to capitalize on these temporary inefficiencies, the opportunity set has largely diminished over the years potentially due to a greater market awareness of the event and its unpredictable impact. Regardless, index investors still need to rebalance their Russell portfolios while carefully balancing the tradeoff between tight tracking error and minimizing market impact and trading costs.
The potential wealth erosion caused by these large index rebalance events has always been the source of much criticism and even more so now as investors continue to gravitate towards index based products. While some argue this point challenges the efficacy of index investing, the benefits surrounding low cost, transparency and liquidity are clear, and as asset managers we continually explore all options to mitigate the impact of these events.
The age old adage that an index manager must precisely track an index irrespective of cost is still widely assumed in the market place. While this may be true in limited cases, State Street Global Advisors is always looking to balance expected tracking error relative to potential transaction costs that result from index rebalances. We can go about this by broadening our trading window during these events, either over the course of the rebalance day, week or even longer but in a risk-controlled manner. We have undertaken exhaustive research to understand how prices and performance have been historically impacted to assist our portfolio managers in determining an appropriate trading strategy in order to meet the objective of closely tracking strategies respective index, while potentially adding value and minimizing transactions costs. This analysis and research is done at all levels (regional, country, sector, etc.). As an example, the Russell 2000 Index rebalance has exhibited changing price behavior over the last 7 years. Between 2010 -2012, there were potential opportunities to add value, even post-announcement date. However, within recent times, the price effect has been volatile, even going “wrong-way” at times and pre-trading strategy being costly. Because of this, trading ‘market on close’ on the rebalance date has often times resulted a more efficient way to getting equity exposure.
Another way we help to reduce liquidity demand is by utilizing our robust internal trading network, broad product set and diverse client base. This network enables trades to be crossed with internal order flow versus having to trade on the open market, which eliminates information leakage and can minimize both implicit and explicit costs.1 Crossing can be done at the unit level in institutional pooled vehicles, as well as at the individual security level in most markets. With that in mind, crossing is relevant when investing or divesting client directed flows but also during index rebalances. Case in point, during the 2018 Russell Reconstitution, 52% of our order flow was crossed internally, resulting in just US$ 7 billion of open market trading activity vs. an estimated US$ 14 billion. Historically, a large portion of rebalance activity during the reconstitution involves index migrations- i.e. a small cap stock moving to a large or midcap index or a growth stock moving to value also presenting internal crossing opportunities. Roughly 80% of all Russell 1000 buy orders were crossed internally during this year’s reconstitution, which was driven mainly by index migrations. Crossing between style indices has also historically been high – around 75% within our Russell 1000 value and growth strategies. So when an investor only has to incur 25% of a massive rebalance trade, it ends up being a tremendous cost savings for them.
Benchmarking against a less commonly used index to gain access to a particular market exposure is another possible solution. The potential for market impact is greatest when there are considerable assets benchmarked to the same index, particularly if turnover is high and stock-level liquidity is low. At State Street, we now offer index strategies that track internally developed cap-weighted indices. Like a third-party index, these strategies are designed with a detailed, rules-based, construction methodology and typically use an external calculation agent to follow these pre-set rules around rebalance periods and provide daily constituents and weights. Moving to internally constructed indexes means that investors not only avoid paying some explicit costs like index licensing fees, but also avoid the demand for liquidity associated with popular benchmarks around popular rebalance dates. When constructing these indices, an off-cycle rebalance date was intentionally selected to avoid having to trade on the same major index rebalance dates used by the other index providers. There is an added advantage of using rules created by a seasoned research team coupled with practitioners/portfolio managers with many years of experience who thoroughly understand issues around liquidity and investabilty. While some index rebalances are notable and highly followed events, overall turnover in most major indexes is very low, typically below 5% per year. Even the Russell Reconstitution’s turnover is low with the Russell 1000 typically less than 4% and the Russell 2000 approximately 20%. These levels are quite a bit lower than the great majority of active strategies. But even with these low turnover figures, transaction cost savings, and ultimately maximizing portfolio value, is always top of mind with us.
1Availability of internal crossing at State Street Global Advisors may be affected by your asset class, vehicle type, jurisdiction or other factors.
Russell 1000 Index: An index designed to track the largest 1,000 stocks in the Russell 3000 Index.
Russell 2000 Index: An index designed to track the smallest 2,000 stocks in the Russell 3000 Index.
The views expressed in this material are the views of Heather Apperson and Raymond Donofrio through the period ended July 27, 2018 and are subject to change based on market and other conditions. This document contains certain statements that may be deemed forward-looking statements. Please note that any such statements are not guarantees of any future performance and actual results or developments may differ materially from those projected.
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