Anyone want to buy or sell this tech rally? Today is a good chance to do it. It’s the annual Russell Reconstitution. Following the rebalancing of S & P indexes last week, on Friday, the Russell Indexes will do their annual rebalancing. It’s technically known as a “reconstitution” because some names are added or deleted to the indexes, in addition to changing the individual weightings in the indexes. Call it the Triumph of Indexing: 20 years ago, these rebalances attracted little attention because there was not much money directly indexed to them. Not anymore. S & P has estimated more than $6 trillion is directly indexed to the S & P 500 alone, and likely even more indirectly indexed. FTSE Russell also has a vast suite of products indexed to benchmarks such as the small-cap Russell 2000 , the large-cap Russell 1000 and the Russell 1000 Growth and Value Indexes. FTSE Russell estimates about $12.1 trillion is currently benchmarked to the FTSE Russell Indexes. Why care about rebalancing? Two reasons: 1) It’s a major liquidity event where a lot of stock is moved around — in fact, it is one of the biggest volume days of the year, and 2) the individual weightings of the constituents will change because the market capitalizations of the constituents have changed over the last year. What’s changing? These indexes are based on market capitalization. Everyone knows the main story of the past year: Technology stocks have gotten bigger — a lot bigger. According to Wells Fargo, the weighting of the largest tech stocks will increase to roughly 29% of the Russell 1000, which Wells Fargo says would be a historic high. The rebalancing will add to the buying pressure on names such as Apple, Microsoft and Nvidia. Why does any of this matter? More managers having to buy tech names may put more upward pressure on the stocks. “This is problematic for active [portfolio managers], as they are already underweight uber-caps,” Chris Harvey, head of equity strategy at Wells Fargo, said in a recent note to clients. Investors in Growth and Value can also be affected. Due to the big rise this year in companies that are listed in the communication services sector (Meta, Netflix and Google), those names will migrate from the Russell 1000 Value Index to the Russell 1000 Growth Index. This matters to style investors: Value will be less tech (AI) oriented, and growth will be more tech (AI) oriented. In addition, different companies will be going into and out of both the Russell 2000 and 1000. On average, about 12% of the Russell 2000, about 242 stocks, turns over every year since 2006, according to FTSE Russell. This year, about 15% of the Russell 2000 will turnover, and about 2% of the Russell 1000, according to Wells Fargo. Many observers have noted that the process of migrating losers out of one index, the Russell 1000, for example, and into another index, the Russell 2000, for example, creates an inherent bias. Mike O’Rourke, chief market strategist at JonesTrading, noted Thursday night that the reconstitution became an annual event in 1989. “From then through 2019 (prior to the pandemic), the average performance of the Russell 2000 in the first half of the year is a 5.5% gain,” he wrote. “Following the reconstitution, the average performance of the index in the second half of the year was 3.5%, hence the bias.” What’s a ‘liquidity event?’ The most important thing about the Reconstitution is it is the last significant “liquidity event” before the summer. A “liquidity event” is an event that generates enormous volumes of stock trading. It could be an initial public offering, it could be options expirations, but index rebalances are usually the largest liquidity events. This gives traders who need to move significant blocks of stock the opportunity to do so without moving prices — hopefully. Suppose you’re a fund manager, and you need to, say, sell 100,000 shares of Amazon, and buy 100,000 shares of Apple and sell 100,000 shares of Freeport-McMoRan … on and on. You have a laundry list of stuff you have to buy and sell, and you know volumes are going to drop as usual in the summer and you need to get this done without moving prices. This is where you do it. This is where traders who don’t particularly care about the Russell Reconstitution can move a lot of stock around and not have it attract too much attention. So, what does it all mean? While this results in enormous volume, the changes in the index are known well in advance. The goal is to move around a lot of stock, hopefully without moving prices. One thing’s for sure: For anyone who has been wanting to buy or sell the tech rally, this is the chance to do it. “Any acute uber-cap demand should be satisfied then due to an expected liquidity surge,” Wells Fargo’s Harvey wrote.
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