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.
FTSE Russell® is a trading name of FTSE, Russell, FTSE TMX and MTS Next Limited. “FTSE®”, “Russell®”, “FTSE Russell®” “MTS®”, “FTSE TMX®”, “FTSE4Good®” and “ICB®” and all other trademarks and service marks used herein (whether registered or unregistered) are trade marks and/or service marks owned or licensed by the applicable member of the LSE Group or their respective licensors and are owned, or used under licence, by FTSE, Russell, MTSNext, or FTSE TMX.
All information is provided for information purposes only. Every effort is made to ensure that all information given in this publication is accurate, but no responsibility or liability can be accepted by any member of the LSE Group nor their respective directors, officers, employees, partners or licensors for any errors or for any loss from use of this publication or any of the information or data contained herein.
No member of the LSE Group nor their respective directors, officers, employees, partners or licensors make any claim, prediction, warranty or representation whatsoever, expressly or impliedly, either as to the results to be obtained from the use of the FTSE Russell indexes or the fitness or suitability of the indexes for any particular purpose to which they might be put.
No member of the LSE Group nor their respective directors, officers, employees, partners or licensors provide investment advice and nothing in this communication should be taken as constituting financial or investment advice. No member of the LSE Group nor their respective directors, officers, employees, partners or licensors make any representation regarding the advisability of investing in any asset. A decision to invest in any such asset should not be made in reliance on any information herein. Indexes cannot be invested in directly. Inclusion of an asset in an index is not a recommendation to buy, sell or hold that asset. The general information contained in this publication should not be acted upon without obtaining specific legal, tax, and investment advice from a licensed professional.
No part of this information may be reproduced, stored in a retrieval system or transmitted in any form or by any means, electronic, mechanical, photocopying, recording or otherwise, without prior written permission of the applicable member of the LSE Group. Use and distribution of the LSE Group index data and the use of their data to create financial products require a license from FTSE, Russell, FTSE TMX, MTSNext and/or their respective licensors.