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VOLUME TWO | ISSUE FIFTEEN

MAY 25, 2011

Investing in Projected Russell 2000 Stock Additions: A Viable Investment Strategy or a Losers Game? | Serbin, Borkovec, Sun
Every year at the end of June, the Russell Investment group reconstitutes its family of indexes. The associated investment opportunities and challenges are evident from the dual goals of indexers and speculators during the Russell reconstitution period: indexers need to keep their tracking errors under control, while speculators are looking to take advantage of the shifting demand and supply for the index additions and deletions. Several studies have focused on the return behavior of portfolios of Russell stock additions and deletions. The consensus in these papers is that the excess demand for Russell stock additions implies positive returns on the spread portfolio which is long in the index additions and short in the index deletions. The reported positive return is realized in the period prior to the effective rebalancing day. However, after the effective day, the return on this spread portfolio turns negative. It is well documented that these return dynamics result in significant losses to long-term index investors (Chen et al., 2005, Cai and Houge, 2008). In this edition of Insights we: Review and extend the existing evidence on return dynamics of Russell 2000 stock additions before the effective rebalancing date to a more recent time period (2005-2010). To the best of our knowledge, there are no published studies on the annual rebalancing of the Russell indexes that use the data after 2005. Vary the portfolio formation date and the stock universe and analyze different scenarios. Specifically, we investigate the profitability of a simple speculative investment strategy that invests in stocks that are anticipated to enter the Russell 2000 index on the effective day. Determining the optimal initiation date for the portfolio is one of the building blocks of this strategy. To identify the other important input of the strategystock selection we build the investment strategy using simulated projections rather than actual stock additions. This approach avoids a look-ahead bias, allowing us to draw practical conclusions, and quantifies the impact of the quality of Russell index projections on the performance of the investment strategy.

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Contributors Vitaly Serbin Vitaly.Serbin@itg.com 617.692.6746 Milan Borkovec Milan.Borkovec@itg.com 617.692.6733 Xuepeng Sun Xuepeng.Sun@itg.com 617.692.6734

Summary
It has long been understood that the relative transparency of the rules guiding Russell indexes rebalancing leads to the profitability of speculative investment strategies1. One of the simplest and most obvious strategies is to buy projected Russell stock additions prior to the effective date and sell them to the indexers on that day. Similarly, one can sell short projected Russell stock deletions and buy them back from indexers on the effective date, although short selling is harder to accomplish, especially in illiquid stocks. Onaev and Zdorovtstov (2007) report an average 11.64% return on the portfolio of Russell stock additions between 2000 and 2005 (the returns are not risk-adjusted) during the period starting 21 days and ending 1 day prior to the effective date. They also report an average 6.77% return on the spread portfolio between
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1

For a complete list of rules for inclusion into Russell indexes please see the document Equity Indexes Construction and Methodology that can be downloaded from the Russell Investment group website www.russell.com/ indexes/documents/Methodology.pdf.

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Investing in Projected Russell 2000 Stock Additions: Viable Investment Strategy or a Losers Game? | Serbin, Borkovec, Sun
stock additions and deletions over the same period. In comparison, Madhavan (2001) reports an average return of 5.12% on the portfolio of Russell stock additions and 6.83% return on the spread portfolio of additions and deletions during the months between March and June in 1996 to 2001. The above results seem to suggest a strong potential for easy and almost risk-free investment profits. However, as always, the devil lies in the details, and the conclusions of those papers must be taken with a grain of salt. First, the above-mentioned papers have not focused on the uncertainty in the Russell index changes, and thus used actual Russell index additions and deletions to derive the reported average returns. In practice, the actual list of stocks going into or out of the rebalanced Russell indexes is unknown until the date on which the preliminary 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 to perfectly forecast all index changes. The second practical limitation of these Russell rebalancing investment strategies are transaction costs that are especially high for less liquid stocks. Consequently, buying or selling Russell stocks that are expected to be added or deleted from the Russell 2000 index can be expensive. In our research, we take the practical approach to analyzing the predictability of the Russell index changes and study returns of the portfolios of predicted index additions that are net of transaction costs. Not surprisingly, the simple investment approach of buying the projected Russell 2000 stock additions and holding them until the effective day loses its attractiveness once trading costs and the uncertainty about the composition of the rebalanced index are factored in. Figure 1 ,below, depicts the average cumulative return on the equal-weighted portfolio of projected Russell 2000 additions from different formation dates to the effective day over the period of 2005 to 2010. Figure 1 contains three average cumulative returns: the blue bars illustrate the average cumulative portfolio returns of actual stock additions and the green and red bars depict the average cumulative portfolio returns of projected stock additions before and after transaction costs were subtracted, respectively. The horizontal axis represents the portfolio formation time: it varies from 8 weeks prior to the ranking date (roughly, the beginning of April, which we call formation week #1) to 3 weeks prior to the ranking date (week #6, around the second week of May). We make several observations. First, portfolios of actual index stock additions exhibit a monotonic decline in return as they are formed later in time. For instance, portfolios formed at the beginning of April yield over 12% average cumulative return until the effective date, while portfolios formed closer to mid-May yield only approximately 4%. This is intuitive, as knowing the new index composition earlier allows for more return opportunities due to stocks fundamentals and to excess demand from indexers. The situation changes dramatically once we consider portfolios of projected index additions which are depicted by the green series. The returns do not depend much on the portfolio formation time and are actually slightly rising as portfolio gets formed later in time (from approximately 2.5% for portfolios formed 7-8 weeks prior to effective date to approximately 3% for portfolios formed 3-4 weeks prior to that date). A possible explanation is the interaction of two opposing effects. As the holding period increases we can capture additional excess return; however, with the earlier formation date the quality of index projections also goes down.
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VOLUME TWO | ISSUE FIFTEEN

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Investing in Projected Russell 2000 Stock Additions: Viable Investment Strategy or a Losers Game? | Serbin, Borkovec, Sun
Figure 1: Cumulative Return on the Portfolio of R2000 Adds (average 2005-2010)
return, % 14 12 10 actual adds projected adds - no costs

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projected add - net of costs 8 6 4 2 0 1 2 3 portfolio formation week 4 5 6

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Accounting for transaction costs results in a further decline in the returns on the portfolios of projected Russell 2000 stock additions. After accounting for costs, the strategy of buying the projected Russell additions yields average returns that range between 1.3% and 2.5% over the period of 2 to 3 months prior to the effective date. Again, the trend of rising returns for portfolios formed closer to effective date is visible (from 1.3% for the portfolios that were formed in early April to 2.5% for portfolios with a formation date in mid May). This indicates that the excess returns on the portfolios of Russell 2000 stock additions documented in the literature do not easily translate into a profitable investment strategy. The quality of the projections, as well as accounting for transaction costs, is important as both can push down the realized net returns of the investment strategy. In our full paper, we describe the specifics of constructing an investment strategy that can still be profitable. In particular, we explore the portfolios that contain only subsets of projected Russell stock additions and vary the date on which these portfolios are formed. In addition, we study the level of forecasting precision necessary to run a profitable investment strategy based on projected Russell 2000 stock additions.

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Investing in Projected Russell 2000 Stock Additions: Viable Investment Strategy or a Losers Game? | Serbin, Borkovec, Sun Results and Conclusions
Our Monte-Carlo simulations reveal that, for any base success rate between 20 and 40%, we can run a consistently profitable investment strategy of $10mln. We define the base success rate p as p = [# of correctly predicted additions] / [total number of actual additions] and vary p from 0.2 to 0.4 with the increment of 0.05 (i.e. we consider five values of base success rate in total). Imposing a simple liquidity filter (dropping 20% of the projected additions that are the most expensive to trade) allows running a profitable investment strategy that captures the same returns with less forecasting skill. For instance, the investment strategy with 30% base success rate and a liquidity filter yields the same returns as the one with 40% and no filters. However, further restricting the universe in terms of liquidity is counterproductive, as the corresponding protfolio returns remain the same or even deteriorate. There is a slight upward trend in the profitability of this investment strategy as the investment portfolio is formed later in time. Forming the portfolio in late April or early May, in combination with a moderate liquidity filter, provides an approximate 2.5% return in excess of the Russell 2000 index with only 20% success rate in predicting the index additions. However, forming this portfolio in the first half of April would result in a 1.5-2% return only. We demonstrate that the projected (non-simulated) list of index additions would very likely omit securities of the companies with very small market capitalization and with a weak recent return performance. Inclusion of these companies into the final rebalanced Russell 2000 index is largely based on the turnaround in their performance and a rapid price runup between portfolio formation and ranking dates. It is likely, however, that the failure to correctly predict the index inclusion of the lowest market capitalization stocks does not matter for the overall performance of most index funds, as they are mostly concerned with maintaining the low tracking error.

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VOLUME TWO | ISSUE FIFTEEN

MAY 25 2011

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Investing in Projected Russell 2000 Stock Additions: Viable Investment Strategy or a Losers Game? | Serbin, Borkovec, Sun

References
Cai J., and Houge T., Long-Term Impact of Russell 2000 Index Rebalancing, 2008, Financial Analysts 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 Reconstitution Effect, 2003, Financial Analysts Journal, Vol. 59-4, pp. 51-64. Onaev Z., and Zdorovtstov V., Russell Reconstitution Effect Revisited. 2007, working paper, available at SSRN: http://ssrn.com/abstract=960727. Serbin, V., Borkovec, M. amd Sun, X., Investing in Projected Russell 2000 Stock Additions: A Viable Investment Strategy or a Losers Game, 2011, Technical Report, ITG Inc. Russell Investments, Russell U.S. Equity Indexes Construction and Methodology, 2011, available at: www.russell.com/indexes/documents/Methodology.pdf.

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2011 Investment Technology Group, Inc. All rights reserved. 052311-28820 The opinions, positions, and/or predictions taken or made in this document reflect the judgment of the individual author(s) and are not necessarily those of ITG. These materials are for informational purposes only, and are not intended to be used for trading or investment purposes or as an offer to sell or the solicitation of an offer to buy any security or financial product. Nothing contained herein should be relied upon as a representation, guarantee, or warranty as to the reasonableness of the assumptions or the 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 recommendations to buy or sell securities, to hire any investment adviser or to pursue any investment or trading strategy. The Frank Russell Company is not affiliated with ITG. RussellTM is a trademark of the Frank Russell Company. The Russell 1000, Russell 2000, and Russell 3000 indices are trademarks of the Frank Russell Company.