The reconstitution of the Russell indexes each year in June represents one of the most important short-term drivers of demand for specific U.S. equities.
Advanced trading strategies of market participants from hedge funds to retail investors focus on accurate prediction of membership and subsequent demand shifts. Savvy investors familiar with the process can predict which stocks might move in or out of indexes, though the process is not as simple as identifying the 2,000 largest companies on the market. Analysis of pricing trends among stock styles and sizes can help investors identify potential beneficiaries or laggards as the indexes are reconstituted.
- Russell Indexes are reconstituted each year to reflect changes in the market capitalization of constituent companies.
- Investors and traders pay close attention as names are added or dropped from the Russell 1000 and 2000 indexes.
- Characteristics such as value vs. growth are also considered and re-evaluated during this process.
Russell Index Reconstitution
Each year in May and June, the Russell Indexes release an updated list of the constituents for their various indexes, notably the Russell 2000 and Russell 1000. Many exchange-traded funds and mutual funds are constructed to track these indexes, so official index rebalances force these funds to transact large volumes of stocks that move in or out of the index. This drives major changes in demand for stocks, generating significant volatility.
The Russell US Indexes are designed to reflect the ever-changing US equity market, and the annual reconstitution process is critical to maintaining accurate representation. When the indexes are reconstituted, the breakpoints between large-, mid-, and small-cap are redefined to ensure market changes that have occurred in the preceding year are captured. Companies are also evaluated to determine where they lie along the investment styles spectrum from value to growth. As a result, companies will be added to, removed from, or swapped amongst the Russell 3000, 2000, and 1000.
The Russell U.S. index methodology takes into account market capitalization, home country, exchange listing eligibility, the price per share, share availability, trading volume, and company structure.
For the reconstitutions, preliminary lists are first compiled and communicated to the marketplace with updates provided throughout June. The newly reconstituted indexes then take effect after the market close on the last Friday in June. The rebalance can generate tilt towards larger companies over small, growth companies over value, and tech/healthcare over the other sectors, for instance.
The largest five companies in the Russell US Indexes have remained unchanged since 2019’s reconstitution, but the order of them has since changed. Apple (AAPL) is again the largest company in the index, followed by Microsoft (MSFT), which is now the second largest company in the index after trading spots with each other. The total market cap of the ten largest companies has steadily increased with each recent reconstitution.
Market Cap Valuation
The Russell 1000 Index represents the top one thousand listed companies by market capitalization in the United States and is a subset of the Russell 3000, To determine the holdings of the Russell 1000, the company ranks all of the stocks included in the Russell 3000 by market capitalization and identifies the market cap breakpoint of the 1,000th stock ranking. This breakpoint is the primary market capitalization used to determine index eligibility.
The Russell 2000 index measures the performance of the 2,000 smaller companies that are included in the Russell 3000 Index. The Russell 2000 is widely regarded as a bellwether of the U.S. economy because of its focus on smaller companies that focus on the U.S. market.
Many stocks are swapped between the Russell 1000 and Russell 2000 at the annual reconstitution however variation around the market cap breakpoint is the determining factor. This can provide trading opportunities as index funds and ETFs that track the Russell 1000 add or remove holdings in order to reflect changes in the index construction and replicate the new index's portfolio.
Because they are closely followed by mutual funds managers and individual investors, speculation as to which companies will be added or removed from the Russell 1000 and 2000 can cause a jolt in short-term demand.
The Price of Growth
Russell also offers a number of index variations derived from the Russell 1000. These variations include the Russell Value and Russell Growth.
Included in the Russell 3000 Value Index are stocks from the Russell 3000 Index with lower price-to-book ratios and lower expected growth rates. Value stocks trade at generally lower prices relative to fundamentals (i.e., lower P/E ratios) and tend to pay higher dividends, making them attractive to value investors.
The Russell 3000 Growth Index, in contrast, is comprised of those companies well-positioned for fast growth. Growth stocks often look expensive, trading at a high P/E ratio, but such valuations could actually be cheap if the company continues to grow rapidly which will drive the share price up. These fast-growing firms (often startups) do not always pay a dividend, given that management usually opts to reinvest retained earnings in capital projects. For this reason, growth investors choose growth stocks based on the potential for capital gains, not dividend income.
These indexes are also evaluated and reconstituted annually in order to preserve its mandate of listing value vs. growth stocks.
Russell index constituency is based on several factors, though market capitalization is the primary determinant. Strong performance among mid-cap stocks could prevent small caps from moving into higher indexes in large numbers. Value stocks, for instance, might be more likely in a given year to move into indexes, while growth stocks on the margins would more likely be dropped.
Growth stocks that fall out of the indexes are often particularly vulnerable because these are typically more volatile. Investors can also expect companies that have suffered due to global macroeconomic volatility to be at risk of exclusion. Basic materials and energy companies are particularly at risk, since low raw material prices can wreak havoc on their bottom lines.