The Russell Stock Market Indexes

The Russell Stock Market Indexes includes several indexes that cover a wide range of stocks that are grouped primarily by market capitalization and are used as either as benchmarks or for the selection of stocks in many financial products, such as exchange-traded funds. These indexes are maintained by the Russell Investment Group.

The Russell Investment Group

The Russell Investment Group, an investment service provider, is the sponsor and creator of the Russell indexes. According to Russell, $3.8 trillion is benchmarked against the Russell indexes.

The Russell Investment Group evaluates fund managers for clients, such as mutual fund companies and companies with large pension funds, and the indexes are a main tool to see how well fund managers perform. The Russell indexes are based primarily on market capitalization, so if a fund manager can't perform better than a Russell index that mirrors the type of stocks that the fund invests in, then the fund manager isn't worth anything. Few mutual fund managers do better than the indexes, especially every year, so why not save on manager and active trading fees by buying the stocks that constitute an index, and simply hold it. That's the idea behind closed-end mutual funds based on indexes, and exchange-traded funds (ETFs), which have the lowest fees of any mutual fund. An exchange-traded fund buys the securities that constitute a specific index in proportion to their market capitalization, and issues new securities based on this basket of stocks. These ETF securities trade on the stock exchange just like any other stock.

The Constitution of the Russell U.S. Equity Indexes

The primary consideration for inclusion in a Russell index is stock market capitalization. The Russell 3000E Index includes, in spite of its name, the largest 4000 publicly traded companies on American stock exchanges. All other Russell indexes are subsets of the Russell 3000E index. E stands for extended, because the Russell 3000 index is extended to include the 1,000 companies in the Russell Micro-Cap index that are not included in the regular Russell 3000 index.

Companies excluded from the Russell indexes include OTC bulletin-board securities, pink sheets, stocks priced less than $1, and all companies not incorporated in the United States.

Index numbers may not be the exact number of stocks represented, because IPOs are added quarterly and deletions occur throughout the year because of corporate actions, spin-offs, or delisting. Stocks removed during the year are not replaced.

The above indexes are core indexes, which are further subdivided into growth and value indexes, called style indexes. To create the style indexes, a composite value score is created by a special algorithm that depends on the price-to-book ratio and the I/B/E/S forecast long-term growth mean of each stock in a given core index. The stocks are then ranked based on this score, which is used to determine the classification of each stock as growth or value, or a combination. Thus, the Russell 2000 Value Index is composed of companies from the Russell 2000 which have a lower price-to-book ratio and lower forecasted growth rates. Note, however, that, in spite of the name, the Russell 2000 Value Index has fewer than 2000 stocks since the Value Index only represents a subset of the Russell 2000 that excludes growth companies.

Because the market capitalization of stocks changes all the time, the Russell indexes are completely reconstituted every year, so that stocks remain in the appropriate index. The preliminary index reconstitution is announced in mid-June based on market capitalizations as of May 31, and the reconstituted index will be effective the final Friday of June. Corporate actions or errors discovered before the final reconstitution can alter the membership of the Russell indexes slightly.

Profiting from the Russell Index Reconstitution

There was an article in The Wall Street Journal (June 3, 2006) about traders making money on the annual Russell Index reconstitutions by buying before the fund managers buy. How profitable is this, really? Now that the list of additions has been published for 2006, it is, evidently for some stocks, very profitable! The following examples were picked randomly, and presented in the order that they were picked. (Although these diagrams are more than 10 years old, they still have pedagogical value.)

As you can see, some of these stocks, peak around April, and then decline. This indicates that the active traders have bought by then, and then buying declines.

What stocks are added to the Russell indexes are based mostly on market capitalization, and the indexes are reconstituted every year. Because about $3.8 trillion worth of index mutual funds and exchange-traded funds are benchmarked against the Russell indexes, any new additions to the Russell index are bought by the fund managers to reflect the changes. Active traders anticipate this by looking for companies that are increasing in market capitalizations, and thus, are likely to be added to the index in June. One study, published in the Financial Analysts Journal, found that between 1990 and 2002, index funds tracking the Russell 2000 suffered 1.3% - 1.84% because of traders buying the stocks before the fund managers.

Of course, fund managers also try to determine what will be added to the index, because if they don't, they'll be buying the stocks at higher prices, which will hurt the fund performance. So, it is the combined buying by active traders and fund managers that drives up the stocks' prices before they are actually added to the index. No doubt some of the stock price declines results when the active traders sell for a profit.

Russell Global Equity Indexes

The Russell Investment Group has also developed the Russell Global Equity Indexes, which provide indexes for other countries, with sub-indexes of their regions and industries. This progression is natural considering that computers have greatly reduced the cost of computing indexes, and the investment world is becoming a more global one.