Even Migrating Stocks Face Index Reconstitution Costs
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Index-tracking funds seek to match an index’s performance, which may lead to constraints and implementation costs that hurt returns.
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Our case study of Russell indices shows that stocks migrating between indices can see increased volume and price pressure around reconstitution.
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A systematic daily process can help avoid the costs of demanding immediacy while providing a consistent focus on stocks with higher expected returns.
In recent research by Dimensional, we examined 10 widely tracked US equity asset class indices over the recent decade and identified significant costs for index-tracking funds from demanding immediacy during index reconstitution. For a cleaner measure of the costs, we focused on nonmigrating securities, i.e., stocks that are added to (or deleted from) an index and are not also deleted from (or added to) another index from the same index family on the same reconstitution date, to avoid the conflicting trading pressure migrating securities may face. However, this does not mean the index reconstitution effect is absent for migrating securities.
In this study, we assess the volume and price pressure associated with Russell 2000 migrating additions and deletions—stocks that migrated from the Russell 2000 to the Russell 1000 and vice versa—over the 10-year period from 2014 to 2023. We chose to examine the Russell 2000 because it’s the more popular index within the Russell family, as identified by assets tracking, and the relatively transparent process by which securities migrate between the Russell 2000 and Russell 1000.
The classification and migration process for Russell stocks is mostly based on stocks’ total market capitalization near reconstitution, with some “banding” around a market-capitalization breakpoint to reduce turnover between the indices.1 This methodology allows us to identify the index reconstitution effect by comparing groups of stocks near the market-cap breakpoint that migrate versus those that stay. In our analysis, we do this by sorting Russell constituents (see Exhibit 1) by their total market capitalization at the month-end nearest rank day and forming four groups of 20 stocks each year.2
Construction of Comparison Groups
For the groups of stocks that we compare against each other, R2 Migrating Deletions versus R2 Largest Stayers and R2 Migrating Additions versus R1 Smallest Stayers, we find similar value-weighted average size, value, and profitability characteristics across the sample period.3 What differentiates the two otherwise similar groups is whether they change index membership. For example, Wingstop Inc. had a total market cap of $5.99 billion as of April 2023 month-end and migrated from the Russell 2000 to the Russell 1000, while Super Micro Computer Inc. had a similar total market cap of $5.56 billion and stayed in the Russell 2000. On the other hand, JetBlue Airways Corp. had a total market cap of $2.34 billion as of April 2023 month-end and migrated from the Russell 1000 to the Russell 2000, while Kohl’s Corp. had a similar total market cap of $2.44 billion and stayed in the Russell 1000.4
Unlike their nonrebalanced counterparts, migrating additions and deletions exhibit abnormal trading volume on reconstitution day as index fund managers are forced to mirror the changes in the Russell indices. Panel A of Exhibit 2 presents the average trading volume in R2 Migrating Deletions and R2 Largest Stayers from 20 trading days prior to reconstitution day, t-20, through 20 trading days following reconstitution, t+20, reported as a multiple of the stocks’ volume on day t-20. Panel B presents a similar comparison but for the R2 Migrating Additions and the R1 Smallest Stayers. We see that the average trading volume spikes by 12x for migrating deletions and 10x for migrating additions while remaining relatively flat for their comparison groups of stayer stocks.
Average Trading Volume Multiples on Reconstitution Day vs. 20 Days Prior, 2014–2023
Panel A: R2 Migrating Deletions vs. R2 Largest Stayers
Panel B: R2 Migrating Additions vs. R1 Smallest Stayers
How does the abnormal trading volume impact the returns of the migrating stocks versus those of the nonrebalanced stocks? Consistent with our findings for nonmigrating additions and deletions, we find evidence of price pressure for Russell 2000 migrating stocks in days leading up to reconstitution with a reversal following reconstitution. Exhibit 3 plots average cumulative excess returns from 20 trading days before to 20 days after the effective date of reconstitution for different stock groups, with the line marking the effective date. The cumulative excess return for each stock on day t is the sum of the excess returns from day t-20 to day t relative to the Russell 2000. We then form a value-weighted average cumulative excess return, with weights proportional to the market capitalizations of stocks in the group, as of the month-end before reconstitution.
As shown in Panel A, the cumulative excess return to R2 Migrating Deletions is -1.1%, on average, in the 20 days leading up to reconstitution. Over the 20 trading days following reconstitution, these stocks see an upward reversal of around 2%, on average. R2 Largest Stayers, however, do not exhibit a clear excess return pattern around reconstitution, with average cumulative excess return values oscillating between 0% and 1% over the time horizon.
Panel B shows a mirror image: The cumulative excess return of R2 Migrating Additions is 1.2% over the 20 trading days leading up to reconstitution, with a reversal of -0.95%. For R1 Smallest Stayers, the cumulative excess return oscillates around 0%, showing no clear pattern.
Average Cumulative Excess Returns Around Reconstitution Day, 2014–2023
Panel A: R2 Migrating Deletions vs. R2 Largest Stayers
Panel B: R2 Migrating Additions vs. R1 Smallest Stayers
Overall, using the Russell 2000 Index as a case study, we find evidence of volume and price pressure for migrating additions and deletions. Although the magnitude of the pressure is smaller than that of nonmigrating additions and deletions in our previous analysis, likely due to conflicting trading pressure, there is still a meaningful cost that can detract from index fund returns. To avoid such costs, we believe a better approach to portfolio design and management would be a daily process that uses information from market prices every day and spreads turnover across all trading days in the year, with flexibility across stocks, quantities, and time. Such an approach can help investors target higher expected returns while avoiding the cost of demanding immediacy from the market.
Footnotes
- 1. Around four to six weeks prior to the annual reconstitution on “rank day,” FTSE Russell sorts eligible US stocks by their total market capitalization to establish a total market capitalization breakpoint between the 1,000th and 1,001st largest stocks, of which stocks ranked 1–1,000 theoretically belong in the Russell 1000 and stocks ranked 1,001–3,000 in the Russell 2000. However, to lower turnover between the two indices, stocks already belonging to either index that fall within a cumulative 5% market-capitalization range around the breakpoint remain in their index and do not migrate.
- 2. For reconstitution events prior to 2017, the month-end nearest rank day is the May month-end. For events in 2017 through 2023, the month-end nearest rank day is the April month-end. In 2019 there were only 18 R2 Migrating Additions, and in 2022 there were only 19 R2 Migrating Deletions. Results were consistent when we limited the group size to 10. Our identification methodology is similar to that presented in Heath et al. (2022), “Do Index Funds Monitor?”
- 3. R2 Migrating Additions (Deletions) exhibit more downward (upward) momentum than their comparison groups, which if anything can weaken the price pressure results.
- 4. This information is intended for educational purposes and should not be considered a recommendation to buy or sell a particular security. Named securities may be held in accounts managed by Dimensional.
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