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At the intersection ofmarkets and technology,Insights provides ITGsglobal perspectives onmarket structure, analyticsand research, and liquidity.

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VOLUME TWO | ISSUE FIFTEEN MAY 25, 2011

Invesng in Projected Russell 2000 Stock Addions:

A Viable Investment Strategy or a Losers Game? | Serbin, Borkovec, Sun

Every year at the end of June, the Russell Investment group reconstutes its family of indexesThe associated investment opportunies and challenges are evident from the dual goals ofindexers and speculators during the Russell reconstuon period: indexers need to keep theirtracking errors under control, while speculators are looking to take advantage of the shiingdemand and supply for the index addions and deleons.

Several studies have focused on the return behavior of porolios of Russell stock addions

and deleons. The consensus in these papers is that the excess demand for Russell stock addions implies posive returns on the spread porolio which is long in the index addions andshort in the index deleons. The reported posive return is realized in the period prior to theeecve rebalancing day. However, aer the eecve day, the return on this spread porolioturns negave. It is well documented that these return dynamics result in signicant losses tolong-term index investors (Chen et al., 2005, Cai and Houge, 2008).

In this edion ofInsights we:

Review and extend the exisng evidence on return dynamics of Russell 2000 stock addi-ons before the eecve rebalancing date to a more recent me period (2005-2010). Tothe best of our knowledge, there are no published studies on the annual rebalancing ofthe Russell indexes that use the data aer 2005.

Vary the porolio formaon date and the stock universe and analyze dierent scenarios.Specically, we invesgate the protability of a simple speculave investment strategythat invests in stocks that are ancipated to enter the Russell 2000 index on the eecveday. Determining the opmal iniaon date for the porolio is one of the building blocksof this strategy. To idenfy the other important input of the strategystock seleconwe build the investment strategy using simulated projecons rather than actual stock ad-dions. This approach avoids a look-ahead bias, allowing us to draw praccal conclusions,and quanes the impact of the quality of Russell index projecons on the performanceof the investment strategy.

Summary

It has long been understood that the relave transparency of the rules guiding Russell indexes

rebalancing leads to the protability of speculave investment strategies1

. One of the simplesand most obvious strategies is to buy projected Russell stock addions prior to the eecvedate and sell them to the indexers on that day. Similarly, one can sell short projected Russellstock deleons and buy them back from indexers on the eecve date, although short sellingis harder to accomplish, especially in illiquid stocks. Onaev and Zdorovtstov (2007) report anaverage 11.64% return on the porolio of Russell stock addions between 2000 and 2005 (thereturns are not risk-adjusted) during the period starng 21 days and ending 1 day prior to theeecve date. They also report an average 6.77% return on the spread porolio between

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1 For a complete list of rules for inclusion into Russell indexes please see the document Equity Indexes Construc-

on and Methodology that can be downloaded from the Russell Investment group website www.russell.com/

indexes/documents/Methodology.pdf.

marketstructure | analyticsan dresearch | l iquidity
http://www.russell.com/indexes/documents/Methodology.pdfhttp://www.russell.com/indexes/documents/Methodology.pdfhttp://www.russell.com/indexes/documents/Methodology.pdfhttp://www.russell.com/indexes/documents/Methodology.pdf

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Viable Investment Strategy or a Losers Game? | Serbin, Borkovec, Sun

stock addions and deleons over the same period. In comparison, Madhavan (2001) reportsan average return of 5.12% on the porolio of Russell stock addions and 6.83% return onthe spread porolio of addions and deleons during the months between March and June in1996 to 2001.

The above results seem to suggest a strong potenal for easy and almost risk-free invest -ment prots. However, as always, the devil lies in the details, and the conclusions of thosepapers must be taken with a grain of salt. First, the above-menoned papers have not focusedon the uncertainty in the Russell index changes, and thus used actual Russell index addionsand deleons to derive the reported average returns. In pracce, the actual list of stocks goinginto or out of the rebalanced Russell indexes is unknown unl the date on which the prelimi-nary version of the revised index is released by Russell Investment group. As a consequence,it is likely that part of the reported returns could not be captured due to the inability toperfectly forecast all index changes. The second praccal limitaon of these Russell rebalanc-ing investment strategies are transacon costs that are especially high for less liquid stocks.Consequently, buying or selling Russell stocks that are expected to be added or deleted fromthe Russell 2000 index can be expensive.

In our research, we take the praccal approach to analyzing the predictability of the Russellindex changes and study returns of the porolios ofpredictedindex addions that are net oftransacon costs. Not surprisingly, the simple investment approach of buying the projectedRussell 2000 stock addions and holding them unl the eecve day loses its aracvenessonce trading costs and the uncertainty about the composion of the rebalanced index are fac-tored in. Figure 1 ,below, depicts the average cumulave return on the equal-weighted poro-

lio of projected Russell 2000 addions from dierent formaon dates to the eecve day overthe period of 2005 to 2010. Figure 1 contains three average cumulave returns: the blue barsillustrate the average cumulave porolio returns ofactualstock addions and the green andred bars depict the average cumulave porolio returns ofprojectedstock addions beforeand aer transacon costs were subtracted, respecvely. The horizontal axis represents theporolio formaon me: it varies from 8 weeks prior to the ranking date (roughly, the begin-ning of April, which we call formaon week #1) to 3 weeks prior to the ranking date (week #6,around the second week of May).

We make several observaons. First, porolios of actual index stock addions exhibit a mono-tonic decline in return as they are formed later in me. For instance, porolios formed at thebeginning of April yield over 12% average cumulave return unl the eecve date, whileporolios formed closer to mid-May yield only approximately 4%. This is intuive, as knowing

the new index composion earlier allows for more return opportunies due to stocks fun-damentals and to excess demand from indexers. The situaon changes dramacally once weconsider porolios ofprojectedindex addions which are depicted by the green series. Thereturns do not depend much on the porolio formaon me and are actually slightly rising asporolio gets formed later in me (from approximately 2.5% for porolios formed 7-8 weeksprior to eecve date to approximately 3% for porolios formed 3-4 weeks prior to that date)A possible explanaon is the interacon of two opposing eects. As the holding period in-creases we can capture addional excess return; however, with the earlier formaon date thequality of index projecons also goes down.

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Accounng for transacon costs results in a further decline in the returns on the porolios ofprojected Russell 2000 stock addions. Aer accounng for costs, the strategy of buying theprojected Russell addions yields average returns that range between 1.3% and 2.5% over theperiod of 2 to 3 months prior to the eecve date. Again, the trend of rising returns for poro-lios formed closer to eecve date is visible (from 1.3% for the porolios that were formed inearly April to 2.5% for porolios with a formaon date in mid May).

This indicates that the excess returns on the porolios of Russell 2000 stock addions docu-mented in the literature do not easily translate into a protable investment strategy. Thequality of the projecons, as well as accounng for transacon costs, is important as both can

push down the realized net returns of the investment strategy.

In our full paper, we describe the specics of construcng an investment strategy that can sllbe protable. In parcular, we explore the porolios that contain only subsets of projectedRussell stock addions and vary the date on which these porolios are formed. In addion,we study the level of forecasng precision necessary to run a protable investment strategybased on projected Russell 2000 stock addions.

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0

2

4

6

8

10

12

14

1 2 3 4 5 6

return, %

portfolio formation week

Figure 1: Cumulative Return on the Portfolio of R2000 Adds

(average 2005-2010)

actual adds

projected adds - no costs

projected add - net of costs

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Results and Conclusions

Our Monte-Carlo simulaons reveal that, for any base success rate between 20 and 40%,we can run a consistently protable investment strategy of $10mln. We dene the basesuccess ratep as

p = [# of correctly predicted addions] / [total number of actual addions]and varyp from 0.2 to 0.4 with the increment of 0.05 (i.e. we consider ve values of basesuccess rate in total).

Imposing a simple liquidity lter (dropping 20% of the projected addions that are themost expensive to trade) allows running a protable investment strategy that captures thesame returns with less forecasng skill. For instance, the investment strategy with 30%base success rate and a liquidity lter yields the same returns as the one with 40% and nolters. However, further restricng the universe in terms of liquidity is counterproducve,as the corresponding proolio returns remain the same or even deteriorate.

There is a slight upward trend in the protability of this investment strategy as the invest-ment porolio is formed later in me. Forming the porolio in late April or early May,in combinaon with a moderate liquidity lter, provides an approximate 2.5% return inexcess of the Russell 2000 index with only 20% success rate in predicng the index ad-dions. However, forming this porolio in the rst half of April would result in a 1.5-2%return only.

We demonstrate that the projected (non-simulated) list of index addions would very likely omit securies of the companies with very small market capitalizaon and with a weak

recent return performance. Inclusion of these companies into the nal rebalanced Russell2000 index is largely based on the turnaround in their performance and a rapid price run-up between porolio formaon and ranking dates. It is likely, however, that the failure tocorrectly predict the index inclusion of the lowest market capitalizaon stocks does notmaer for the overall performance of most index funds, as they are mostly concernedwith maintaining the low tracking error.

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salesandtrading:

800.433.3804

mediainquiries:

800.814.1134

investorrelations:

800.991.4484

[email protected]


VOLUME TWO | ISSUE FIFTEEN MAY 25 2011

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References

Cai J., and Houge T., Long-Term Impact of Russell 2000 Index Rebalancing, 2008, FinancialAnalysts Journal, Vol. 64-4, pp. 76-91.

Chen, H., Singal, V. and Noronha, G., Index Changes and Losses to Index Fund Investors,2005, Financial Analysts Journal, Vol. 62-4, pp. 31-47.

Madhavan, A., The Russell Reconstuon Eect, 2003, Financial Analysts Journal, Vol. 59-4,pp. 51-64.

Onaev Z., and Zdorovtstov V., Russell Reconstuon Eect Revisited. 2007, working paper,available at SSRN: hp://ssrn.com/abstract=960727.

Serbin, V., Borkovec, M. amd Sun, X., Invesng in Projected Russell 2000 Stock Addions: AViable Investment Strategy or a Losers Game, 2011, Technical Report, ITG Inc.

Russell Investments, Russell U.S. Equity Indexes Construcon and Methodology, 2011, avail-able at: www.russell.com/indexes/documents/Methodology.pdf.

2011 Investment Technology Group, Inc. All rights reserved. 052311-28820

The opinions, posions, and/or predicons taken or made in this document reect the judgment of the individual author(s) andare not necessarily those of ITG. These materials are for informaonal purposes only, and are not intended to be used for tradingor investment purposes or as an oer to sell or the solicitaon of an oer to buy any security or nancial product. Nothing con-tained herein should be relied upon as a representaon, guarantee, or warranty as to the reasonableness of the assumpons orthe accuracy of the sources used by the author(s). These materials do not provide any form of advice (investment, tax or legal).ITG Inc. is not a registered investment adviser and does not provide investment advice or recommendaons to buy or sell securi-es, to hire any investment adviser or to pursue any investment or trading strategy. The Frank Russell Company is not aliatedwith ITG. RussellTM is a trademark of the Frank Russell Company. The Russell 1000, Russell 2000, and Russell 3000 indices aretrademarks of the Frank Russell Company.

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