Is Your Stock About to Russell Up?

Is your stock on the verge of leveling up? Join Jeff Praissman and NASDAQ’s Nicole Torskiy as they break down the mechanics, impact, and market drama behind index additions- just in time for the upcoming Russell rebalance.

Summary – IBKR Podcasts Ep. 270

The following is a summary of a live audio recording and may contain errors in spelling or grammar. Although IBKR has edited for clarity no material changes have been made.

Jeff Praissman 

Hi everyone, this is Jeff Praissman, and it’s my pleasure to welcome to the IBKR Podcast NASDAQ’s Director of Economic Research, Nicole Torskiy. Welcome, Nicole. How are you? 

Nicole Torskiy 

I am doing great. Thanks so much for having me on again. How are you doing? 

Jeff Praissman 

I’m doing great. It’s great to have you back in the studio, and I’m really excited for our conversation today on index rebalancing and tracking. 

Nicole Torskiy 

Me too—especially with the upcoming Russell Rebalance on June 27th. 

Jeff Praissman 

Nicole, I think before we even start our discussion, it’s probably important to clarify for our listeners that when indexes make changes, they don’t actually trade. They just add or delete symbols or change the weights around. But the funds tracking them—the ones that hold the stocks—are the ones that actually need to trade. 

Nicole Torskiy 

Yeah, that’s a really important point. Indices are just rules-based benchmarks used to track asset performance. They don’t own any assets themselves. Index funds—mutual funds and ETFs—that track the index are the ones that buy and sell stocks to match the index. 

Jeff Praissman 

And I think it makes a lot of sense to maybe start off with a quick explanation for our listeners on why indexes rebalance. 

Nicole Torskiy 

Of course. So, indices are designed to represent a specific market or market segment. Index reconstitution and rebalance make sure that an index is correctly reflecting the market it’s designed to track. Indices adjust index constituents—or reconstitute—to account for changes in market capitalization, mergers and acquisitions of companies within the index, new listings, and delistings. 

Without that reconstitution, the index wouldn’t be representing the market anymore. Think of the S&P 500: it was launched in 1957, but the 500 biggest companies in the U.S. today aren’t the same as they were in 1957. The index needs to change as the market changes. Then the funds tracking the index adjust their holdings—or rebalance—by buying stocks of index additions, selling stocks of index deletions, and adjusting positions in stocks with weight changes. This makes sure the tracking fund correctly reflects the performance of the index. 

Jeff Praissman 

So, Nicole, what are the mechanics of an index removing and adding stocks? And also, I guess more importantly, how does a fund manager replicate this virtual trade on the index’s part most efficiently to minimize tracking errors? 

Nicole Torskiy 

Yeah, so for each index provider, it starts with a set of rules that they use to determine what companies are eligible for the index. These rules can look at a stock’s liquidity, price, free float, sector, and how long it’s been trading. For the major U.S. market indices, after the index provider determines the eligible universe of stocks, they rank the stocks by market cap—and the company’s rank determines what index it’ll be included in. 

So once ranking and index membership are decided, the index providers share this information and fund managers can prepare for the index trade. For example, the FTSE Russell indices ranked companies for the Russell 3000 on April 30th, shared preliminary addition and deletion lists starting May 23rd, and the index reconstitution is final after the close on Friday, June 27th. This means fund managers need to have replicated the index changes in their portfolios before market open on June 30th—at the June 27th closing price. 

The easiest way for a fund manager to do this and minimize tracking error is to sell index deletions and buy index additions at the same time and prices as the index. Index funds trade in the closing auction on index reconstitution days. 

Jeff Praissman 

During these quarterly and yearly rebalances, how does the market volume change? 

Nicole Torskiy 

We see some pretty significant changes. Market volume shifts heavily to the closing auctions on rebalance days, as funds trade in the close to replicate the index changes. On a typical day, about 5% of volume is traded in the closing auctions. On rebalance days, we see about 15% of volume in the close for MSCI, 20% for S&P and Nasdaq-100 rebalances, and over 25% of market volume trades in the closing auction on the day of the Russell Reconstitution. 

Overall, what we see is about one and a half times more value traded on a Russell Reconstitution day—but most of that activity is in the closing cross. Four times more value trades in the close than on a typical day—and nine times more volume. 

Jeff Praissman 

So it’s definitely a significant increase. Are the funds adding the shares immediately, or are they trading them over time to minimize market impact? 

Nicole Torskiy 

Great question. Index funds aren’t like traditional active mutual funds. Traditional active funds pick stocks they think will perform well and trade them secretly over time to minimize market impact and keep as much of the outperformance—or alpha—as they can. Traditional funds are measured by how much they beat the market return. 

Index funds, on the other hand, are measured by how closely they match market returns. So instead of maximizing alpha like a traditional fund, index funds aim to minimize tracking error. In fact, for most large index funds, tracking error is close to zero. To do this, index funds need to replicate the index’s rules-based reconstitution as closely as possible. So funds trade all the shares they need to sell and buy immediately on Recon Day. 

Jeff Praissman 

And you mentioned earlier that they do this on the close. How do they trade that much more than a normal close? 

Nicole Torskiy 

On Recon Day, the index removes and adds stocks at the last price of the day—or the closing price. The day’s return of deletions and the overnight return of additions are going to be accounted for in the index. To correctly replicate the index change, index funds must sell removed stocks and buy added stocks at the closing price—and then hold the added stocks before market open the next day. 

This results in funds needing to trade in the close to minimize tracking error. If the fund fails to trade in the close, they would still own the deleted stocks the next day and miss the overnight returns with the added stocks—resulting in tracking error. 

The how part is interesting. Index funds need to execute a very large trade in a very short period of time—and they make up a significant portion of our market. Index funds—including index ETFs—are about 30% of professionally managed assets in the U.S. and half of all mutual funds. 

This creates a lot of demand for index adds on rebalance days. But like we discussed, index reconstitution changes are announced ahead of time. So for a hedge fund or liquidity provider, there’s an obvious trade: buy the stocks being added to the index ahead of time, sell them to the index funds during the rebalance, and short-sell the index deletions. Forecasting additions and deletions is common, and we see liquidity in index additions pick up months in advance of a rebalance. 

Jeff Praissman 

Interesting, interesting. And pivoting a little bit—it seems like it’s a really big deal for a company to be added to a major index, like any of the Russell indexes you mentioned. Maybe especially for a smaller company that isn’t jumping from mid-cap to, say, large-cap, but is just being added to a major index for the first time. 
What are some of the benefits for that company’s stock? 

Nicole Torskiy 

So it is a big deal. There’s a lot of benefit to index additions for a company. We see turnover—or liquidity—increase in new Russell 2000 additions up to six months before the annual reconstitution. And better liquidity is good for a stock. The illiquidity premium goes down with quicker trading, narrower spreads, and valuations can go up. 

Plus, index addition guarantees long-term holders. Index funds don’t need to trade much outside of rebalance. So a company added to an index gains immediate long-term investment. We estimate as much as 10% of a company’s float is held by index funds for stocks in the Russell 2000—12% for the S&P 400. A small-cap in the Russell 2000 and S&P 600 could have 27% of its float held by index funds. 

Jeff Praissman 

And Nicole, I’d imagine conversely, if a stock’s removed from an index, it could have potentially negative effects on the price. 

Nicole Torskiy 

So unfortunately, yes. Just like index addition is good for a stock, removal from an index causes a large sell event—which can depress price. 

Jeff Praissman 

So Nicole, this has been great. Any final thoughts you’d like to leave our listeners with? 

Nicole Torskiy 

Sure. Indexes are an ever-changing landscape and growing more popular. Passive assets are now around 54% of all managed equity, with over $20 trillion in indexed assets globally. Understanding how indices work, trade, and how to get into an index is important. 

We’ve got a key change to look forward to next year: the Russell indices are moving to a semi-annual reconstitution in June and November. So companies will have the opportunity to be added twice a year, and there’ll be one more trading day with a lot of volume in the close as funds rebalance. 

Thank you so much for having me on again. This was great. 

Jeff Praissman 

It’s our pleasure. And I want to remind our listeners that you can find more from Nicole and Nasdaq on the education section of our website. Just click on “Education”—you’ll find podcasts, webinars, and articles from Nicole and our colleagues at Nasdaq. Until next time, Nicole, thank you so much for stopping by.