Russell Rebalance Trade

There was an interesting article in Barron’s over the weekend, The Trouble With Transparency by Bill Alpert, about the rebalancing of the Russell 2000 index.  On the last trading day of May, the 29th this year, Russell Investments takes a snapshot of the market.  It lists all the stocks by market cap starting with the biggest first.  The first 1000 stocks are the Russell 1000.  The next 2000 constitute the Russell 2000.  Then on June 29th they publish the final list.  The index mutual funds that track the Russell indices then have to buy the new constituents of the index and sell the stocks that fall out of the index.

There is $2 trillion dollars in mutual funds and ETFs tracking the Russell 1000 and $870 billion tracking the Russell 2000.  So there is a lot of money rebalancing at the end of June.

Here is a table, from the Barron’s article, of stocks that are not in the Russell 2000 that may be included next month.

Compare this with the bottom of the Russell 2000 as it stands now.

The first two stocks listed on this table are the lowest market cap stocks in the Russell 2000. Eleven and twelve million dollars in market cap, more like micro-caps.

So one way to trade this is to buy the stocks in the first table and short the stocks in the second table.  There are a few issues to think about when doing something like this.

1) You want to pair up the longs and shorts by industry.  That way you are less affected by the overall movement of the sector for the time that you hold the stock.

2) You want to match up the beta of the stocks you are long with the beta of the stocks that you are short.  That will take out the effect of the overall movement of the market.  Beta is the correlation of the stock with the market as a whole.

3) Most funds cannot hold stock that trades for less than a dollar, some will not hold stocks that trade for less than $5.  In the second table I didn’t include stocks that traded for less than $1 except the first two.