June may be the beginning of the summer slowdown for many people. But if you want to take advantage of index funds and other big institutional investors, June brings you an early Christmas present: advance warning of massive sales of unwanted stocks.
Ever year, Russell Investments makes changes to its benchmark indexes, adding some new stocks and taking out ones that no longer make the grade. The indexing giant is probably best known for its small-cap Russell 2000 index, but according to Forbes, institutional investors have $4.2 trillion in assets that are benchmarked to various Russell indexes, with the bulk tied to the large-cap Russell 1000 index.
Falling from glory
Although the process won't be complete until Friday, Russell has already announced some of its prospective additions and deletions from its indexes. As it happens, many well-known companies will have to say goodbye to Russell's broadest measure of the U.S. stock market, the Russell 3000. Many of the deletions are based on market cap, but bigger companies get the boot if their share prices fall below $1 or move to foreign countries. Here are a few of them:
|
Stock |
Market Cap |
1-Year Return |
|---|---|---|
|
Sirius XM (NASDAQ:SIRI) |
$1.35 billion |
(80.1%) |
|
Blockbuster (NYSE:BBI) |
$142.3 million |
(70.6%) |
|
Ingersoll-Rand (NYSE:IR) |
$6.6 billion |
(45.0%) |
|
Capstone Turbine (NASDAQ:CPST) |
$160.3 million |
(79.6%) |
|
Finisar (NASDAQ:FNSR) |
$283.6 million |
(55.3%) |
|
Fannie Mae (NYSE:FNM) |
$707.0 million |
(97.2%) |
Sources: Russell Investments, Yahoo Finance.
Meanwhile, some up-and-coming stocks will find their way into the Russell indexes, such as Hemispherx Biopharma (AMEX:HEB).
What it means
The most important thing about major changes to indexes is that because so many institutional investors work hard to match index returns, changes result in a flurry of trading activity during the transition period. With most indexes, though, including the S&P 500 and the Dow Industrials, changes aren't made on a regular basis. Instead, substitutions are made more on an as-needed basis, which limits the opportunity for traders to take advantage of index funds and other index-tracking investors.
The Russell reconstitution, however, is remarkable because of its regularity. Many investors rush to buy shares of newly added companies in an attempt to beat the index funds to the punch. To try to reduce the impact of the changes, Russell lengthens its process to give institutional investors more time to make trades and realign their portfolios to match up with the new lists.
Can you profit from the changes?
Nevertheless, the predictability of the changes imposes a cost on those who follow the index's changes strictly. Past research has concluded that the forced behavior that index changes impose on the funds that follow them costs investors an average of 2 percentage points every year.
A more recent look at this year's stocks suggests that those conclusions continue to be true. According to a Goldman Sachs study, stocks expected to be added this year have outperformed the overall index by 3.4 percentage points between April 1 and May 4. Stocks to be removed, on the other hand, have underperformed by 6.5 percentage points over the same period.
Nevertheless, some index-trackers prefer not to deal with Russell's annual process. Although the iShares Russell 2000 (IWM) tracks Russell's small-cap index, the Vanguard Small-Cap ETF (VB) chooses to follow a different index, the MSCI small-cap index. That helps the Vanguard fund avoid the June madness.
What to do
With so many hedge funds and sophisticated investors trying to take advantage of the short-term impact on stocks affected by the Russell reconstitution, you're unlikely to cash in with a swing trade. However, that doesn't mean you should ignore the process entirely.
If you own shares of companies that are slated to be removed from the index, then you might want to sell shares before the final reconstitution on June 26 in order to avoid the selling pressure resulting from the index changes. Alternatively, if you really think a stock has good long-term prospects, make sure you're prepared for a potential drop on that day -- and don't panic-sell after the fact.
Conversely, if any of the stocks on the prospective list of additions are attractive to you, you might want to buy sooner than later. If being included in the index pushes share prices higher, you'll be glad you didn't wait.
More on how to invest like a pro:
- Things are already worse than the Great Depression.
- Five traits of great stocks.
- Five stocks to tap for the coming rally.
