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Strategies for Exploiting Index Rebalancing?

| | Posted in: Miscellaneous

A reader suggested: “With the annual Russell rebalancing coming later this month, maybe you could post some profitable trading strategies.” A search of the Social Science Research Network (SSRN) for “index rebalancing” and “index reconstitution” and “Russell rebalancing” and “Russell reconstitution” locates the following research (in reverse posting chronology):

“Index Rebalancing and Long-Term Portfolio Performance” (March 2007):

“We examine how index additions and deletions affect long-term benchmark performance. Studying changes to the small-cap Russell 2000 index from 1979-2004, we find that a buy-and-hold portfolio significantly outperforms the annually rebalanced index by an average of 2.22% over one year and by 17.29% over five years. These excess returns result from strong positive momentum of index deletions and poor long-run returns of new issue additions. We also document the influence of index changes on small-cap equity fund returns. Index deletions enhance the benchmark-adjusted returns of the strongest performing funds by an average of 1.45% per year. Among weaker performing funds, the benefits from holding index deletions are offset by the poor returns of new issues added to the index, which the stronger performing funds generally avoid.”

“Russell Reconstitution Effect Revisited” (February 2007):

“We argue that the recent changes in reconstitution procedures introduced by the Frank Russell Company to ease the migration of affected constituents into and out of index-tracking portfolios, as well as continued growth in the size of speculative capital devoted to the event merit another study of the Russell reconstitution effects. We build upon Madhavan (2003) and conduct a more direct test of the role of order flow imbalances and liquidity changes on returns of Russell 3000 additions and deletions. Our results support both price pressure and index membership hypotheses. While index deletions are heavily sold far ahead of, during, and long after the event, the trading of additions is focused close to the event date. We find that the Russell reconstitution effect weakens during the more recent years. Price pressure-induced reversal effects are found to be much smaller to nonexistent in the recent years.”

“Index Changes and Losses to Index Fund Investors” (August 2006):

“Because of arbitrage around the time of index changes, investors in funds linked to the S&P 500 Index and the Russell 2000 Index lose between $1.0 billion and $2.1 billion a year for the two indices combined. The losses can be higher if benchmarked assets are considered, the pre-reconstitution period is lengthened, or involuntary deletions are taken into account. The losses are an unexpected consequence of the evaluation of index fund managers on the basis of tracking error. Minimization of tracking error, coupled with the predictability and/or pre-announcement of index changes, creates the opportunity for a wealth transfer from index fund investors to arbitrageurs.”

“Market Reaction to Changes in the S&P SmallCap 600 Index” (May 2006):

“Firms added to (deleted from) the S&P 600 index experience a significant price increase(decrease) at announcement. Firms that newly enter (exit) the S&P universe experience a larger price increase (decrease) than firms that move between S&P indexes. Trading volumes are higher after the announcement and institutional ownership increases (decreases) following index additions (deletions). However, the price and volume effects are temporary and are fully reversed within 60 days, in contrast to the permanent effects reported for S&P 500 changes. Our results support the temporary price pressure hypothesis and are similar to results reported for Russell 2000 index changes.”

“On Russell Index Reconstitution” (March 2002):

“This paper investigates whether abnormal returns exist due to transparent changes in domestic U.S. Russell equity indexes. Newly-listed (delisted) companies in the Russell 1000 and Russell 2000 indexes have significant positive (negative) abnormal returns in May and June but not in July. Newly-listed companies in these Russell indexes have significant positive abnormal returns on the reconstitution date, not on the announcement date. This may be due to the reticence of money managers to rebalance their portfolios prior to the reconstitution date in order to avoid tracking error. This study provides evidence that some firm attributes are changed when a company is added or deleted from the Russell indexes. In addition, changes in attributes predict the excess returns associated with index reconstitution. Finally, using intraday data from TAQ, we find that Russell inclusion and deletion is associated with some permanent changes in liquidity.”

“The Russell Reconstitution Effect” (September 2001):

“The equity indexes of the Frank Russell Company are widely used as performance benchmarks for investment managers. Once a year, at the end of June, the Frank Russell Company reconstitutes its stock market indexes. We document economically and statistically significant abnormal returns associated with the annual reconstitution from 1996-2001. The cross-sectional variation in abnormal returns is explained by both permanent changes in liquidity associated with changes in index membership and temporary effects related to price pressure. Our results suggest that passive index funds pay a steep price for minimizing tracking error by rebalancing on the date of reconstitution. Conversely, there are substantial rewards to supplying immediacy to such funds. However, trading on index revisions involves risks arising from sectoral movements and from timing risks as positions are unwound. Indeed, we document dramatic return volatility on the actual day of reconstitution that reflect unanticipated order imbalances.”

In aggregate, these summaries suggest price effects associated with short-term demand and reversal effects associated with addition and deletion of stocks from indexes, which may have diminished in recent years. For individual investors, the trading friction associated with any attempt to exploit the effects are likely problematic.

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