- 2001: Volume 10, No. 3 Ask Dr. Index: Beware the Ides...er... the First of July!

Julius Caesar’s ignorance of a soothsayer’s warning was a set-up for—how shall I put it—a surprise. Most of us don’t get messages of such import so bluntly telegraphed. Those keeping tabs on the equity market, however, know that some "surprises" can be reasonably anticipated. Like the addition or deletion of stocks into certain market benchmarks. Every summer, in fact, the U.S. equity world undergoes a bit of a makeover as the Russell family of capitalization weighted indexes is rejiggered to reflect current market conditions.

"So," I hear you ask, "why should I care?" Because a whole lotta moola is benchmarked to these metrics: $175 billion, in fact. These indexes serve as backbones for three futures contracts (with associated options), one cash index option, and nine exchange traded funds. According to its creators, the stocks making up the Russell 3000® Index, the granddaddy of the family launched in 1983, represents approximately 98 percent of investable U.S. equity.

Index rebalancings are seen as bellwethers by investors. Portfolio managers, it’s reasoned, are inclined to buy stocks earmarked to join popular indexes like the Russells. Doing so minimizes a portfolio’s ‘tracking error,’ or variation from the general market trend. And, as you might imagine, money runners are also thought to be likely dumpers of stocks that are nixed from widely-followed market indicators.

A Russell reconstitution’s fairly straightforward. The company first ranks all U.S. common stocks, from largest to smallest market capitalization, as of May 31, the annual reconstitution date. Russell sets itself apart from other index providers by screening from its benchmarks such hard-to-trade issues as those trading below $1 per share, "Pink Sheet" and bulletin board stocks, closed-end funds, non-U.S. domiciled issues, and ADRs.

The biggest 3,000 stocks wiggling through the screen become the Russell 3000 Index. That list is then carved into two subsets, with the largest 1,000 stocks becoming the Russell 1000® Index and the remaining smaller cap stocks becoming the Russell 2000® Index.

This dispassionate and public approach to index construction, according to Russell chief operating officer Craig Ueland, is more objective and responsive to market changes than a judgement-based committee decision. "By comparison," says Ueland, "the index-by-committee process is slow and cumbersome." Certainly, this methodology allows investors to better predict the stocks which will be added to or deleted from the indexes and to manage their portfolios more accordingly.

Adjustments to Market Cap
Not all shares issued by a company, however, are available to the investor marketplace. Shares held by company founders, directors, and employee ownership plans, for example, are typically restricted from public trading. To better represent the shares actually available for general purchase, Russell long ago decided to remove closely-held and illiquid shares from its index component floats. Since portfolio managers cannot typically buy these shares, Russell asserts such tweakings make their benchmarks more realistic as index fund bases.

For an index complex built from a "total market" base like the Russell 3000, which reaches into small cap territory, this is an important feature. Closely held stocks and crossholdings can make up 50 to 80 percent of many smaller issuers’ float, especially Internet companies where equity is often largely held as restricted stock by insiders and venture capitalists.

Adjustments like these make indexes more "macroconsistent." In this context, macroconsistency reflects the dampening of index tracking error. Managers of large portfolios charged with replicating an index on a full-float basis may find themselves competing with one another for a supply of shares limited by off-market holdings. Unable to elbow its way into the market to grab the stock’s full-float weight, the portfolio could veer markedly from the actual market, especially if the stock is highly volatile (know of any Internet stocks that haven’t been volatile in the past year?). This tracking error represents risk—a risk that fund investors, thinking they were ‘buying the market’—might not have thought they were taking.

Index Maintenance
Russell’s indexes are classic "low-maintenance" vehicles. They’re reconstituted once a year, based upon the market snapshot taken on May 31. The new index register takes effect July 1, and remains in place until the following year’s reconstitution. When rejiggered, the eponymous indexes aptly describe the number of underlying component companies. Over time however, stocks can be pared from the benchmarks’ rosters due to mergers, acquisitions, delistings and other corporate events. The only additions allowed between reconstitutions are spin-offs. And then only relatively large spun-off companies are eligible for addition to the parent company’s capitalization tier. Mark Hansen, director of global sales at Russell/ Mellon Analytical Services, emphasizes that frequent reconstitutions may better reflect current market compositions, but can also make indexes more difficult and expensive to use as portfolio frameworks. "The current Russell practice was selected," says Hansen, "as the best tradeoff between these two options."

Index Style Slants
Russell’s Weltanschauung isn’t limited to capitalization. Investors seeking specific exposures to value or growth stocks can use Russell style indexes to more finely balance their portfolios. Based upon their relative price-to-book ratios and forecasted long-term growth rates, Russell ranks each base index’s component stocks according to their value or growth slant. This process is applied separately to both the Russell 1000 and Russell 2000 indexes in order to preserve the integrity of each benchmark’s valuations. Under Russell’s proprietary methodology, roughly 70 percent of each indexes’ companies end up being classified as either growth or value stocks. The market value of these stocks then goes to populate either the value or growth index at the appropriate capitalization tier. The stocks remaining, approximately 30 percent, have some portion of their market value assigned to both the value and growth indexes, based on the degree to which they lean to one style or the other. Since stocks are always fully represented in the base index by the combination of their growth and value weights, a stock that is given say, a 20 percent weight in the value index will have an 80 percent weight in the growth index. Since a stock can appear in both value and growth indexes at its capitalization tier, the sum of number of stocks in the style indexes can exceed the number of stocks comprising the base index.

"As a rule," said Caesar, "men worry more about what they can’t see than about what they can." Russell’s method of assigning stocks to its growth and value indexes may be proprietary, but the basic stock selection methodology is pretty transparent. That should take some of the worry out the upcoming index reconstitution.

I’d still worry, though, about accepting speaking invitations before a group of men in togas.

Dr. Index is Brad Zigler, head of marketing and investor education at Barclays Global Investors Services. Dr. Index can be contacted at www.ishares.com/dr_index/qa.jhtml. Any strategies discussed, including examples using actual securities and price data, are strictly for illustrative and educational purposes and are not to be construed as an endorsement, recommendation, or solicitation to buy or sell securities. The examples presented do not take into consideration commissions, tax implications or other transaction costs, which may significantly affect the economic consequences of a given strategy.

More information on the Russell indexes can be found at www.russell.com. Details on Russell iShares funds are at www.ishares.com.

All Russell Index composition statistics provided by Barclays Global Investors as of March 31, 2001. There are risks involved in investing, including possible loss of principal. The Russell 1000, Russell 2000 and Russell 3000 Indexes are unmanaged indexes. You cannot invest in an index.