Russell Investments begins the process of rebalancing its indexes at the end of next month, and the industry is already starting to wonder if this year’s rebalance will see increased speculative activity, or if the impending Volcker rule will mean less liquidity coming from proprietary trading desks.
In the last two years, the Russell rebalance has been relatively orderly on reconstitution day, meaning buys and sells have been able to pair off without too much market dislocation—at least when compared to the large order imbalances seen during the financial crisis.
This year’s June 22 rebalance, however, could be affected by the Volcker rule’s requirement that banks divest themselves of their prop desks, according to Phil Mackintosh, global head of trading strategy for Credit Suisse.
“If all other things were equal, I would say this year would probably continue that trend, and the trade would get closer to being matched, but I think Volcker is the elephant in the room,” Mackintosh said.
While many banks seem to have already purged their prop trading businesses, it is still unclear where all of those prop traders have gone.
“We don’t know if they’ve started up hedge funds,” Mackintosh said. “We don’t know if the hedge funds have the same capacity and risk appetite as the prop desks used to have, same access to borrow as they used to have. We just don’t know.”
Each year, the rebalance requires huge amounts of liquidity toward the end of June when Russell posts final membership lists for its indexes. In order for the reconstitution of the indexes to run smoothly, some traders have to take speculative positions that prepare for index funds buying the new names in the indexes and selling the stocks that have been dropped.
In 2006 and 2007, speculators went a bit overboard, causing a “wrong way” rebalance in which they overbought the stocks added to the indexes and had too many shorts on the stocks being left off. The credit crisis changed all that, and in 2008 and particularly in 2009 the speculative community largely avoided the Russell rebalance, leading to a “right way” rebalance, and index funds struggled to get enough liquidity in the names they needed to change.
Though some rule changes still kept speculators away in 2010, last year saw a more typical rebalance in which there was a fair amount of liquidity available for index funds. The question now is whether speculators will be able to match the rebalance with the inventories they have built up in the months ahead of the reconstitution.
Charles Behette, a director at ITG, said this year’s reconstitution will likely be similar to the one last year. Though turnover in the Russell indexes is currently projected to be lower this year than in 2011, Behette said speculators will still be looking to enhance their own performance through the Russell rebalance.
“There are a lot of mutual fund managers being compared to ETFs, and they’re looking to enhance their returns this year to differentiate themselves,” Behette said. “I think some people will look at this as an opportunity to pick up some alpha in the market.”
But Credit Suisse’s Mackintosh said mutual funds have gotten more conservative about the rebalance trade in recent years after getting burned in the past. He said it is still anyone’s guess if speculative trading will meet the demands of index funds on rebalance day.
May 31 is the ranking date at which Russell determines market caps. The company releases a preliminary list of stocks in its 2012 indexes on June 8, and new indexes become effective at the close of reconstitution day, June 22.
