Index funds give investors an easy way to invest in the stock market. But because index funds have gotten so popular -- and so big -- following the ins and outs of how their underlying indexes work has captured the attention of opportunistic traders seeking quick profits at the expense of long-term traders. If you're quick on your feet, you may be able to beat those traders at their own game and pick up shares of the stocks you want at a bargain price.
The next big rebalancing
Earlier this week, the Nasdaq announced that it would rebalance its Nasdaq-100 index for the first time in 13 years. The move had a huge impact on several of the nation's top tech stocks, which saw their weightings within the index changed dramatically. Many anticipated that the resulting buying and selling by index mutual funds and ETFs could have a big effect on share prices.
But even with the Nasdaq's move still several weeks away, some are already turning their attention to the annual rebalancing of the Russell indexes, including its popular small-cap Russell 2000 index. Even though Russell won't complete its rebalancing process for another two months, traders are getting a head-start speculating which stocks might become eligible for the small-cap benchmark.
What's at stake
The idea behind trying to game index rebalancings is pretty simple. When index overseers add a stock to an index, the funds that track that index are forced buyers. To be certain that they'll be able to match the index's performance, funds have to buy shares of the new components. As a result, demand rises astronomically for new index additions as they become part of popular benchmarks.
For small-cap stocks like those in the Russell 2000, that can make a huge difference. Although the Nasdaq 100 rebalancing got a lot of attention, the stocks involved are so huge and have such high trading volume that index funds don't have to worry much about liquidity being a problem. But small-cap stocks often trade far fewer shares than their large-cap counterparts. And given that investors had nearly $4 trillion tracking various Russell indexes as of last year, there's enough money at stake to put plenty of pressure on illiquid small-cap stocks.
With this year's rebalancing not happening until June 24, it seems early to start thinking about it now. Yet analysts at Charles Schwab's equity research unit have actually suggested that with more investors paying attention to rebalancing, buying as soon as late March would have made sense.
The stocks to buy
So which stocks are likely to get added to the Russell 2000? By looking at stocks with appropriate market capitalizations that aren't yet in the index, you can get a sense of which stocks are likely candidates. Here are five:
||1-Year Total Return
|Hyperdynamics (AMEX: HDY )
|KEMET (NYSE: KEM )
|Bronco Drilling (Nasdaq: BRNC )
|NN, Inc. (Nasdaq: NNBR )
|Hurco (Nasdaq: HURC )
Source: Schwab, Yahoo Finance.
It's important to realize that plenty of high-flying small-caps won't make this list because they aren't eligible for inclusion in the Russell 2000 for other reasons. For instance, Rare Element Resources (AMEX: REE ) and North American Palladium (AMEX: PAL ) have market caps in the right range, but they're both headquartered in Canada and therefore can't be in the U.S. index.
What to do
There's no guarantee that these companies will actually get added to the Russell 2000 in June. For one thing, after such big moves up for most of these stocks, a reversal could carry shares downward just as quickly.
So rather than simply buying these stocks as a short-term trade, you may prefer to pick particular stocks that you believe are good long-term investments and then look at beating the crowd to the party. Even if something happens and the stock you like doesn't end up in the index, you won't be disappointed -- because you'll still have a strong stock.
Index rebalancing events happen all the time, and they draw a lot of attention. By steering clear of the hype and focusing instead on the things that are important to you as a long-term investor, you'll get better results no matter what happens.
Want to be the first to know if these stocks end up in the Russell? Add them to your watchlist and don't miss anything.