TECH TUESDAY is a weekly content series covering all aspects of capital markets technology. TECH TUESDAY is produced in collaboration with Nasdaq.
On Friday, June 28, we will see the annual Russell reconstitution. It’s typically the biggest close of the year (Chart 1, orange dots), which is impressive, considering it doesn’t coincide with a triple-witch date like the S&P rebalances do.
Chart 1: Closing auctions are much larger on index rebalance dates
Russell indexes are important for a number of small-cap companies. Being added to the Russell 2000 means you are also part of the larger Russell 3000 index. Because those 3000-ish companies are part of major fund benchmarks, their turnover tends to be higher, which helps reduce trading costs. Companies will also find that they have new long-term investors (in the form of index funds) who own their stock.
This year, brokers estimate there will be around $150 billion in net trading, representing net buying and selling of different stocks. Russell’s May 24 announcement has a number of new stock additions and deletions to each index:
- Russell 1000 (Large Cap): 10 additions (including DELL, CRH and SN) and 28 promotions from the Russell 2000 (including SMCI, MSTR, CVNA and PR). The smallest company in the index will be LEG, with a market cap of around $2.4 billion.
- Russell 2000 (Small Cap): 213 additions (including VERX with a total market cap of $4.5 billion) and 30 demotions from the Russell 1000, as well as 143 deletions. The largest company in the index will be AIT, with a market cap of around $7 billion, while the smallest company in the index will be RELL, with a market cap of around $150 million.
Note that the largest company in the small-cap index is bigger than the smallest company in the large-cap index. That’s done to reduce trading from year to year. In short, a company needs to get much bigger to be promoted to the large-cap index, which should mean it can shrink a little without demoting the very next year.
Index changes result in unusually large volumes
We recently detailed why index funds don’t need to trade on most days. However, they do need to trade when the index changes (which happens using close prices). That’s why index change dates have unusually high market-on-close volumes.
Index funds represent as much as half of all mutual funds, which can result in a lot of trading when changes occur. So, it’s no surprise that we see unusually high volumes on index rebalance days. In fact, the data in Table 1 below shows that although the total value traded is less than double a normal day, the close is roughly 4-times bigger than normal by value and almost 9-times larger by shares.
Table 1: Comparing a normal day to Russell Recon Day in 2023
Why do index funds mostly trade in the close?
Index funds aren’t like traditional active mutual funds.
Traditional active mutual funds pick stocks that are expected to outperform. They then trade them as secretly as possiblein order to keep as much outperformance as they can. At the end of the year, they are primarily measured by how much they beat the market return. Said another way, they are trying to maximize alpha.
In contrast, index funds are primarily measured by how closely they match the market return. In other words, they are trying to minimize tracking error.
We can see that’s true by looking at how the QQQ ETF tracks its Nasdaq-100 benchmark below. For most large index funds, tracking error (or the difference between daily fund returns and index returns) is almost zero.
Chart 2: Performance of the QQQ index fund completely matches the Nasdaq-100 Index
How do index funds minimize tracking error?
The easiest way for an index fund to minimize tracking errors is to do exactly the same thing that the index does, but to their portfolio at exactly the same time.
When an index removes (or deletes) a stock, the index:
- Includes returns from the deleted stock for the day before it is removed (orange line below).
- Returns from an addition are included for the next day. However, “next day returns” include the gains or losses overnight (purple line below).
So, in reality, the deletion is removed, and the addition is added at the same time, using the “last price” of the day (the market-on-close or MOC price).
In most markets, including the U.S., the last price of the day comes from the closing auction. That is why index funds prefer to trade in the close auction – and why MOC volumes are so large.
Chart 3: Example of how indexes rebalance
Although it’s true that trading near to 4 p.m. should also result in trade prices that are close to the official close price, every second adds to risk that an index fund manager misses their benchmark price, which creates tracking error.
When we look at the VWAP curve for the day of the 2022 Russell index trade, we see that the MOC saw trading that averaged 10 days of normal volume in the instant of the close auction. In contrast, although volumes trading in the minutes before the close were elevated, they were still just over 1% of a normal day’s ADV.
Chart 4: Although trading increases into the close, the MOC itself can be where the majority of trading occurs
This suggests index funds not only prefer the close price, but the majority of their trading also happens in the close.
How much do index funds own of each stock?
If that’s the case, we can also use MOC trading to estimate the market share of index funds across an index.
In Chart 5, we see the close trading volumes (as a proportion of total shares outstanding) for index additions each year.The proportion is pretty consistent across stocks and from year to year.
Based on the data below, we estimate that a company added to the Russell 2000 should expect to have new Russell index funds owning around 9% of its free-float shares. In contrast, being added to the Russell 1000 results in a small proportion of index ownership – at around 4%.
Chart 5: Index tracking as a percentage of shares outstanding for the most popular U.S. indexes
Somewhat counterintuitively, these results also mean that being “promoted” from the small-cap (Russell 2000) to the large-cap (Russell 1000) actually leads to a net reduction in index ownership – and a large sell in the rebalance close.
How do index funds trade that much on the close?
This all shows that index funds need to execute a very large trade in a very short period of time. Typically, this would cause a significant market impact.
For a hedge fund or other liquidity provider, there is an obvious trade: buy the adds before index funds need to trade and sell to index fund buying (and short sell the deletes).
Interestingly, despite index funds getting bigger and more popular, recent research seems to suggest that the profitability of index trades is falling.
We can see this in Chart 6 below, where the S&P adds and deletes:
- In the 90s, when index funds were new and growing, buying additions (and selling deletes) early led to gains for liquidity providers.
- Since the early 2000s, despite continued growth in index funds, this pattern has reversed.
That also means the liquidity costs for S&P index funds trading adds and deletes has been far lower. In fact, for such large trades, the market impact index funds have may be even smaller than what active traders would see trying to build similar sized positions.
Chart 6: Index tracking as a percentage of shares outstanding for the most popular U.S. indexes
The research suggests the same has happened to other U.S. index rebalances, too.
Russell changes are quite different from S&P index changes in a couple of ways:
- Forecasting additions and deletions confidently is much easier, as Russell’s rules are less subjective. That reduces the risk of doing a forecast trade.
- However, Russell 2000 additions are often relatively illiquid. Being added, as we saw in Chart 4, that can require 10 (or sometimes much more) days of liquidity to be accumulated by liquidity providers. This increases the time needed to accumulate the trade and, thus, the risk of holding the trade.
That makes the liquidity provision different, too. We see from the data in Chart 7 that hedge funds seem to start trading Russell adds and deletes as many as five months in advance — that’s when liquidity for additions starts to pick up.
This all makes having a good closing cross important
Closing auctions are important every day, as they are the prices used to invest mutual fund cashflows, calculate fund returns and, importantly, match liquidity while minimizing stock volatility.
The size of the index trades makes them even more important on an index trade date.
Different exchanges have their own listing and trading rules. Consequently, the close works a little differently depending on where a stock is listed. We show the latest key rules for NYSE and Nasdaq listings below, where we color the differences.
Table 2: Closing auction rules for Nasdaq and NYSE listings
The main difference between both closes is the amount of discretion allowed for select participants in the close. NYSE allows traders more order types that allow them to cancel firm orders late in the day, while Nasdaq is focused on reducing imbalances and minimizing volatility.
Nasdaq’s open and close are also more automated and “deterministic.” That can be seen in the time it takes to close the market on the Russell trade date. For example, last year:
- Nasdaq traded 2.5 billion shares across 3,956 symbols with a value of $62.8 billion in less than 1 second.
- NYSE closed with 40% fewer stocks but took almost 4 minutes longer to set its MOC prices.
Chart 7: Number of stocks in the close and time to complete all auctions by listing exchange
Addition is good for your stock
For companies, being added to an index is good — it is a source of additional demand for shares.
- Firstly, by index funds, which are, by definition, some of the most stable and long-term investors available (as long as the company stays in the index).
- Then, also by active funds (which will be underweight all of the additions as soon as the reconstitution trade has happened).
FTSE Russell estimates that if you include active funds, a total of $10.5 trillion is benchmarked to its U.S. indexes. Over time, even more mutual funds are likely to end up owning added stocks.
That’s also important for liquidity. The chart below shows that volumes for newly added stocks remain elevated even well after the index rebalance trade in June. That, in turn, makes it easier for investors to complete larger-sized trades and for companies to raise capital.
Chart 8: Increase in liquidity for Russell 2000 additions starts months before index addition and remains elevated afterward
Addition to the Russell can make a big difference to a small company
Nasdaq lists the majority of companies that will enter the Russell indices each year.
Next week marks the day hundreds of companies enter the Russell indexes for the first time, broadening their universe of potential investors. This adds new opportunities, improves liquidity for investors, and reduces the costs of capital for issuers.
In short, it’s a big day for small companies.
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