The Feedback Effects of Index Rebalancing

Today is a huge day for those who trade index-linked products but under-the-radar for those who don’t. This is when the Russell indices rebalance.  Unlike the S&P 500 (SPX), which rebalances quarterly — most recently on last week’s quarterly expiration – and have additions and deletions on an ongoing basis, the Russell indices rebalance once a year.  Today is that day.

An article on CNBC’s website highlights many of the factors that should make today’s events relevant to ordinary investors.  According to that report, FTSE Russell estimates that over $12 trillion is indexed to Russell products.  That is far too big of a pool of money to ignore.  The effects of the indices’ reweighting have been felt for some time and could result in an unwelcome change in market leadership.

Perhaps the most familiar Russell index is the Russell 2000 (RTY), a bellwether for small stocks.  IWM is a very popular ETF that is based upon that index, and futures and options based upon that index and ETF are actively traded.  We recently wrote an entire piece devoted to RTY after a brief period of outperformance earlier this month.  We were skeptical about whether the rally was a genuine move into small cap stocks or simply traders chasing an underperformer, wondering:

It is indeed welcome to see a rally broaden, but we have to wonder whether this is simply momentum traders cashing in and attempting to move into laggards rather than a meaningful vote about smaller stock outperformance. 

In retrospect, it is quite possible that a catalyst for the early June rally was the “lock-down” period for the index reconstitution that occurred on June 6^th.  Whatever the rationale, since then, SPX has largely caught up, and the two indices are moving in rough lockstep:

32-Day Chart of September Futures, RTY (red/green hourly bars), ES (blue line)

Source: Interactive Brokers

As well known as RTY is to ordinary investors, it is easy to forget that it is really the bottom two-thirds of the Russell 3000 index.  Indeed, there are 1,000 larger stocks that matter to the index reconstitution that is occurring today, and that offers an important consideration about feedback effects.  As the linked CNBC article notes, tech will rise to a roughly 29% weighting in the Russell 1000. 

That could prove to be a significant concern for investors who have become accustomed to mega-cap tech stock leadership over the coming weeks.  Investors who closely track index rebalancing are keenly attuned to the stocks that will likely need to be bought and sold as a result.  In the case of SPX, index changes occur relatively quickly after they are announced.  In the case of Russell, where many of the RTY constituents are thinly-traded, the process begins about two months in advance and is updated at various intervening points. 

Consider what has occurred among large-cap stocks since the end of April.  Put simply, the biggest got bigger.  The recent AI enthusiasm was a key catalyst, but one can’t ignore the fact that as these companies’ market capitalizations grew faster than their peers, the indices would need to be more heavily weighted to those leaders.  That is the feedback effect to which we referred.

And now what?  If some of the recent outperformance of mega-cap tech stocks was the result of this feedback loop, then it is reasonable to be concerned that these stocks could underperform in the ensuing days when the reweighting is behind us.  Ironically, its most notable effect would be upon the NASDAQ 100 (NDX) if that is indeed the case.

Regardless of the short-term effects, it now becomes clear that many index investors are heavily weighted in tech, regardless of whether they want to be or not.  That could be a very good thing if AI enthusiasm continues or if we see inflows into broad-based, large-cap indices.  Yet it leaves many investors unwittingly exposed to a volatile sector that has benefited from narrow market leadership.  It’s a risk that needs to be considered, even if it exists deep in the background of one’s long-term investments.