By: Mat Lystra, Sr. Research Analyst
Come the end of June, the constituents of all Russell indexes – and the ETFs and passive funds that track them – will be updated during the annual index reconstitution. While the Russell recon effectively keeps our indexes in line with their stated objectives, some observers fear that it could lead to unnecessary losses to passive investors from opportunistic “front-running” by traders during the reconstitution process. Over the 2003-2007 period Russell implemented several changes to its transparent reconstitution process in order to reduce unnecessary trading and to achieve a better balance between liquidity supply and demand. Russell 2000 numbers demonstrate these measures have been successful in reducing index turnover.
As passive index-linked funds seek to track the performance of their underlying index, changes in index constituents can result in a large volume of trading by passive funds and ETFs. FTSE Russell and many other index providers publicly announce planned index changes considerably in advance of index reconstitution. While such notice allows passive managers and liquidity providers to prepare for index changes, it can also give rise to the possibility that liquidity providers are able to make large profits from the known trades that passive managers will make.
Recognizing this possibility, Russell implemented an important index methodology change in 2007. Banding was introduced to reduce unnecessary trading, both in the number of different stocks traded and total trading volume. Banding reduces turnover in the Russell indexes by not moving a stock between two indexes unless the percentage difference between company market capitalization and the relevant market capitalization breakpoint exceeds 5%.
The table below shows that the average number of different stocks added to and deleted from the Russell 2000 declined greatly in the eight years of reconstitutions using the banded methodology from 2007 to 2014 compared to the seven years from 2000 to 2006.
Average number of stocks and index-relative weight in the Russell 2000: 2000-2014
Combining adds and deletes in this table, the average number of different stocks traded declined from 872 to 430, a reduction of more than 45%. Considering their total weight in the Russell 2000, their average total weight declined from 39.6% to 16.4% of the index, a decline of more than 58%. Clearly banding greatly reduced the trading necessary to implement index changes.
Reduction in turnover is a good thing in itself, effectively reducing the costs incurred by passive index tracking and capital gains distributions to taxable investors. However, in a follow-on post we'll explore the larger question: how has this reduction in turnover and other changes in index methodology affected index performance?
 For more information on the Russell banding methodology see Russell US Indexes Construction and Methodology, April 2016. For further analysis on the impact of index reconstitution on the performance of the Russell 2000, please read: Russell 2000 Reconstitution Effects Revisited.
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