June 19, 2015 / 5:16 AM / 4 years ago

Top performing health stocks face boot after Russell rebalance

NEW YORK (Reuters) - The Russell 2000 index of small company stocks will lose some heavy hitters from the healthcare sector when FTSE Russell rebalances its indexes at the end of the month, depriving the index of companies that provided much of its growth this year.

A trader works on the floor of the New York Stock Exchange shortly after the opening bell June 2, 2015. REUTERS/Lucas Jackson

Rebalancing the Russell 2000 and the Russell 1000 happens once a year, mainly on the basis of changes in market capitalization. As companies move from one index to another, managers of index-following funds are forced to buy or sell shares so as the mimic the performance of the index. That means they’ll have to sell some healthcare shares, just as those shares hover near their peaks.

Anywhere between 25 to 40 stocks have become too big for the Russell 2000, and will move to the large cap Russell 1000 .RUI.RYY, analysts said. About ten of those will be from the healthcare industry, the largest shift of any sector.

Stocks in the sector that are expected to be promoted to the larger cap index include Isis Pharmaceuticals Inc ISIS.O, up about 86 percent since the last rebalance; Puma Biotechnology Inc PBYI.N, up more than 105 percent over the same time frame; Intrexon Corp XON.N, up 101.3 percent; and Bluebird Bio Inc (BLUE.O), up 334 percent.

At the same time, about 40 other healthcare companies with market caps as low as $177 million will be added to the Russell 2000 index, forcing the index-mimicking managers to buy the shares. Those companies include Advaxis Inc (ADXS.O), Neogenomics Inc (NEO.O), Aduro Bioech Inc (ADRO.O) and XBiotech Inc (XBIO.O)

Through the close on June 18, the Russell 2000 .TOY had risen 7.92 percent on a total return basis, with 4.76 percentage points, or about 60 percent of the total advance in the index, coming from healthcare companies, according to ETF.com data since the rebalance in the prior year by Russell on June 27.

About $45 billion in index fund assets track the Russell 2000 index, slightly more than double the $22.1 billion invested in Russell 1000-tracking index funds, according to Morningstar.

The automatic selling of healthcare shares could protect investors in Russell 2000-tracking funds by locking in some of their profits while the sector is riding high, though it could also force them to leave some future earnings on the table. As a result of the strength among biotechs within healthcare, Bank of America Merrill Lynch has recommended investors be selective in the group as gains may be harder to come by.

Healthcare stocks constituted 16.4 percent of the Russell 2000 on June 12, just before Russell announced a preliminary list of additions and deletions. After the reweighting at the end of the month, healthcare will be 15.5 percent of the index, Bank of America Merrill Lynch said, based on the preliminary announcement. “Healthcare stocks have been really strong performers and their market cap is going to be above the $4.3 billion or so cut off point” for the Russell 2000 index, said Steve DeSanctis, small cap strategist at Bank of America Merrill Lynch in New York. Basically, the index “is getting rid of a few big ones and getting a bunch of smaller ones being added.”

MID CAP INVESTORS TO SEE SHIFT

Funds following the Russell 2000 index will sell those health care companies as soon as the final rebalancing is announced at the end of June; some active managers have already made trades in advance of the Russell announcement.

Healthcare companies have seen $260 billion in merger and acquisition activity over the last year, the second biggest M&A sector behind energy at $265 billion, according to Thomson Reuters data. Should that activity begin to slow, it could signal a component behind the fast growth of small cap healthcare names is starting to dwindle just as they move out of the Russell 2000.

Investors in the larger cap funds could see their weighting of healthcare stocks inch up from 14.6 percent to 14.8 percent, according to BofA/Merrill.

“Those forty names coming into the Russell 2000, those are the ones that are more likely to show the dynamic growth - or the dynamic failure,” said Chad Dale, Director of Index Research at ITG in Toronto. 

Reporting by Chuck Mikolajczak; editing by Linda Stern and John Pickering

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