- The Russell 2000 Index reconstitution is a major event in the US equity calendar, which presents risk management challenges for some and potential alpha trade opportunities for others.
- Reconstitution day is typically one of the highest trading-volume days of the year in US equity markets.
- Here we explore ways to manage exposure and implement trade ideas using E-mini Russell 2000 Index futures and BTIC transactions.
The rebalance happens, simply put, because markets change and evolve. The annual reconstitution ensures that the Russell US Indexes are recast to reflect changes in the US equity markets over the preceding year in accordance with the transparent, public, rules-based methodology.1
During the multi-week rebalancing process, concluding this year on June 26, changes in market capitalization, sector composition, company rankings, and style orientation are captured to be reflected in the new index composition and allows the different indices to remain representative of the benchmarks they are targeting.
There are over 10,000 publicly traded companies in the US market. FTSE Russell, the index administrator, ranks these by total market capitalization. The largest 3,000 become members of the Russell 3000® Index. In turn, these 3,000 component firms are segmented by size to determine the large-cap Russell 1000® Index and the small-cap Russell 2000® Index.
The Russell Reconstitution plays a critical role in ensuring consistency, transparency and reliability of US equity market measures for global investors. Many investors consider the Russell 2000 Index to be the most comprehensive indicator of the US economy due to its breadth of industries as well as its constituents central exposure to the United States.
The annual reconstitution is one of the most significant drivers of short-term shifts in supply and demand for US equities, often leading to sizable price movements and volatility in individual company names or industry sectors. The final day of the reconstitution is typically one of the highest trading-volume days of the year in US equity markets.
This closely watched market event impacts more than $9 trillion2 in investor assets benchmarked to or invested in products based on the Russell US Indexes. The event can create risks for investors who are tracking these indices to ensure they have minimal performance slippage versus their benchmark index. Similarly, it can create opportunities for investors seeking to benefit from the price moves which may be created from the reconstitution.
Countless ETFs, mutual funds, and managed asset programs mirror the composition of the Russell US Indexes in their investment funds, structured products, and index-based derivatives. With close to 70% of actively-managed institutional US equity assets currently benchmarked to a Russell Index, changes to index composition are apt to reverberate widely across the market.3
There are several scenarios in which the use of CME E-mini Russell 2000 Index futures (RTY) can help to mitigate risk for investors tracking the Russell 2000 Index and aid investors who are seeking to benefit from price movements of relevant US equities.
Investors who are tracking the index from a long perspective will often hold physical shares in the correct proportions prior to the reconstitution. To eliminate tracking error versus the index, the investor must buy all the additions to the index and sell all the deletions on the cash close of the reconstitution day. Furthermore, each stock which remains in the index is likely to change its percentage weight higher or lower and this change in weight needs to be replicated by the investor’s share hedge. Operationally, this means an investor must trade over 2,000 stocks and ensure they trade the exact quantity of shares correctly for each individual name.
The same principle holds true for clients who have short positions, with the added complication that an investor must source all the relevant locations to short each individual name that remains within the index.
In either case, the adjustment is susceptible to operational error, which may lead to index tracking error.
Rather than having to execute trades across 2,000 or more individual names, an investor could simply trade CME E-mini Russell 2000 Index (RTY) Futures contracts in lieu of stocks. The benefit of holding a futures position is that the investor does not have to trade the reconstitution themselves. The futures contract will track the index and there will be no tracking errors incurred by trying to replicate the reconstitution.
A long holder may replace their physical exposure with RTY exposure via two avenues:
- A BTIC (Basis Trade at Index Close) transaction in RTY futures allows an investor to enter a futures position by reference to the closing value of the index itself. By buying RTY futures via a BTIC transaction and selling a comparably sized cash portfolio on the close, for instance, the investor can replace the stock position with minimal slippage.
Conversely, a short holder of index exposure can sell RTY futures via a BTIC transaction and buy in shares on the cash close. This strategy can be deployed in advance of the reconstitution and can be averaged over several trading sessions in accord with the investor’s preferences regarding execution costs and market impact costs. BTIC transactions may be executed either on the CME Globex electronic trading platform or as privately negotiated block trades (if the transaction is large enough to meet block trading standards).4 5
Get more details on BTIC and how it works - An Exchange for Physical (EFP) transaction allows an investor to exchange shares for an equivalently scaled number of RTY contracts, and then to carry the resultant futures position through the index rebalancing. Following index reconstitution, the investor may either execute a second EFP trade, to move the index exposure back into a portfolio of shares or may continue to hold the index exposure in futures contract form for better capital efficiency. This mechanism would hold true for BTIC as well.6
Get more details on EFP and how it works
Some investors may carry mandates that allow discretion, prior to index reconstitution, as to the composition of the cash index baskets that may be used for equitizing fund cash flows. In effect, any such investor is permitted to attempt to benefit from price movements in stocks being added or deleted to the index. The investor can use RTY futures as part of the core portfolio holdings to better manage notional discrepancies between the additions and deletions of index constituent stocks.
Typically, such investors attempt to predict in advance, the additions and deletions to the Russell 2000 Index and manage these positions in the run-up to the constitution becoming formalized.
Especially in the small- and mid-cap equity share arena, it is often tactically preferable to trade addition candidates versus the benchmark and deletion candidates versus the benchmark, rather than to trade the prospective additions versus prospective deletions via outright trades in the underlying stocks. From the standpoint of reliable liquidity, ease of execution, capital efficiency, and transparency of pricing, this can be well implemented with E-mini Russell 2000 Index futures.
These futures contracts can be executed intraday to manage notional risk around cash basket adds or deletes and can also be used to target the cash close via a BTIC transaction.
A related challenge is that intraday liquidity in small-cap shares tends to be much thinner than in large-cap stocks. Additionally, traffic in small-cap stocks, more than in large caps, tends to be concentrated at the daily close and, to a slightly lesser degree, at the daily market open.
Trade at Cash Open (TACO) allows traders to execute a basis trade on the Russell 2000 futures relative to the day’s official cash index opening level – before the market open. Liquidity at the closing bell can mean that this is the most opportune time to trade index additions and deletions ahead of the reconstitution. In either case, an offsetting BTIC or TACO trade in RTY futures offers a convenient tool for the investor who wants to remain hedged, whether in notional exposure terms or in beta exposure terms.
On May 8, FTSE Russell posted its preliminary lists of companies set to enter or leave the Russell 3000 Index. The preliminary list contains 143 projected additions and 205 projected deletions for the Russell Indexes.7
The total US equity market capitalization, as reflected by the Russell 3000 Index, is down 1%, yet the market cap of the 10 largest US stocks is up more than 23% as compared to the 2019 reconstitution.
While overall capitalization for the US equity market stayed relatively flat this year, there was a notable divergence between the large- and small-end of the US equity market, driven by the relative strength of US large-caps over the past year. The “Big Got Bigger and the Small Got Smaller.” 8
The market cap breakpoint separating small-caps (Russell 2000 Index) and large-caps (Russell 1000 Index) decreased by more than 16%, and the smallest US company falls below $100 million for first time since 2009.9
Conversely, the large end of the US equity market grew significantly in the last year, with the total combined market cap of the 10 largest companies increasing by 23.3% since the 2019 rebalance. For the first time in the history of Russell US Indexes, there are companies exceeding $1 trillion in total market cap, with three names achieving this milestone. Technology dominates the top five.
E-mini Russell 2000 Index (RTY) futures can be a cost-efficient tool for shifting risk, and a convenient alternative to cash market instruments. Among RTY’s market characteristics are deep liquidity and substantial open interest – two key features for anyone concurrently trading futures and cash index exposures.
In addition to allowing market participants to hedge macro exposures or anticipated directional movements in the Russell 2000 Index, RTY futures can provide a cost-efficient vehicle to assist with market capitalization spread strategies.
For example, a portfolio manager expecting small-cap stocks to outperform large-cap stocks could enter an intermarket spread strategy combining purchase of RTY futures and sale of an equivalently-sized number of E-mini S&P 500 Index (ES) futures contracts. At this writing, the CME Clearing margin spread credit is 80% for a position scaled to 2 RTY long (short) versus 1 ES short (long).10
RTY futures likewise can furnish users with a means to utilise intra-market price discrepancies. A trader can enter a calendar spread, for example, by buying September RTY contracts and selling an equivalent exposure in December RTY contracts, if an opportune price discrepancy emerges between the two delivery months.11
The Exchange’s listings include companion options on RTY futures, enabling a wide array of option spread strategies and Russell 2000 Index volatility plays. CME Group also offers futures products based on the Russell 2000 Growth Index and the Russell 2000 Value Index, potentially useful for many purposes, including cash equitization solutions and tactical asset allocation.
In the run-up to the reconstitution, investors managing assets benchmarked to the Russell 1000 Index or Russell 2000 Index, and receiving subscription and redemption flows, may find it easier to use E-mini Russell 1000 Index (RS1) futures, the Russell 1000 Total Return Index futures or the E-mini Russell 2000 Index (RTY) futures, respectively, to manage equitization of those cash flows. This may help avoid the need to trade cash index baskets with potentially volatile prices. E-mini Russell 2000 Index futures can be traded on CME Globex or, if flows are tied to the close, by executing a BTIC transaction.
1www.ftserussell.com/press/ftse-russell-announces-2020-russell-us-indexes-reconstitution-schedule
2https://www.ftserussell.com/press/ftse-russell-begins-32nd-annual-russell-us-indexes-reconstitution
3https://www.ftserussell.com/indexes/index-linked-products/ftse-russell-etfs
4All BTIC transactions must be executed in accordance with CME Rule 524.B. (“Basis Trade at Index Close (“BTIC”) Transactions”), the Market Regulation Advisory Notice concerning Rule 524 and the provisions in the applicable product chapter.
5Pursuant to the requirements of CME Rule 526 (“Block Trades”).
6For information on exchange-for-related-position transacting, including EFRPs, here: See also CME Group, Block Trades, Market Regulation Advisory Notice RA1906-5, and Rule 538.
7https://www.ftserussell.com/press/ftse-russell-begins-32nd-annual-russell-us-indexes-reconstitution
8https://www.ftserussell.com/blogs/2020-russell-recon-big-getting-bigger-and-small-getting-smaller
9https://www.ftserussell.com/research-insights/russell-reconstitution/market-capitalization-ranges
10Performance bonds, also known as margins, are deposits held at CME Clearing to ensure that clearing members can meet their obligations to their customers and to CME Clearing. Performance bond requirements vary by product and by market volatility levels and are subject to review and revision by CME Clearing. For up-to-date information regarding margin credits on intermarket spread positions, visit: https://www.cmegroup.com/clearing/margins/inters.html#pageNumber=1
11As with intermarket spread positions, potentially significant margin offsets may apply to intra-market calendar spread positions. For current information on margin credits that CME Clearing applies to intra-market calendar spread positions, visit:https://www.cmegroup.com/clearing/margins/intras.html#pageNumber=1&sortField=exchange&sortAsc=true&exchange=CME§or=EQUITY+INDEX&clearingCode=RTY
