NEW YORK (Reuters) - Largecap technology and healthcare sectors are expected to see a bump in weighting when index provider FTSE Russell completes its annual refresh of its benchmarks on Friday, as investors brace for what is annually the largest stock trading day of the year.
The reconstitution of the Russell indexes happens each year on the fourth Friday in June. Stocks are added or deleted to the Russell 1000 large cap and Russell 2000 small cap, prompting fund managers to adjust their portfolios to reflect new weightings.
Strong performances by smallcap healthcare and technology stocks over the past year are expected to lead to a graduation to the largecap Russell 1000. Grubhub, Nektar Therapeutics and bluebird bio are among the companies expected to be added to the largecap index.
Passive funds will rebalance on the day of the reconstitution to minimize any tracking error, while active managers try to take advantage of any price dislocations, resulting in a surge of volume toward the market close.
“The rebalance affects index space, mutual funds and index space ETFs and any active manager that is using the Russell as a benchmark to try to differentiate themselves in that regard,” said Todd Rosenbluth, Director of ETF and Mutual Fund Research at CFRA in New York.
As of Dec. 31, about $9 trillion was benchmarked to or invested in products based on Russell U.S. indexes, according to FTSE Russell. Of the $9 trillion, approximately $1.2 trillion are in passive investment products such as exchange traded funds (ETFs) and mutual funds.
“It is all about going with the flow that day, kind of feeling if it is crowded or not and then which direction they are going to take it,” said Dennis Dick, head of markets structure, proprietary trader at Bright Trading LLC in Las Vegas.
“Sometimes it can get very crowded, and if the crowd goes the other way then the adds can actually go down, especially in the last few minutes before they are going in on the fourth Friday, and the deletes can go up,” Dick said.
According to Nasdaq, last year’s rebalance resulted in more than 972 million shares, representing $28.9 billion, executed during its “closing cross” in 0.861 seconds.
Both the Nasdaq and New York Stock Exchange have contingency plans in place in the event of any system disruption that would impact closing trades, including a market-wide conference call for market participants.
Credit Suisse currently anticipates about $62 billion in turnover across Russell indexes, while ITG sees total turnover at $54 billion. Last year’s reconstitution is estimated to have resulted in total turnover of $50 billon.
The graduation of some healthcare and tech stocks will reduce the weighting of those sectors among smallcaps.
Steve DeSanctis, equity strategist at Jefferies in New York, expects tech to lose about 6 percent in the Russell 2000 growth index.
If a manager was benchmarked to smallcap growth with a neutral weighting on tech and did not recalibrate to the changes, they would then find themselves 6 percent overweight the sector on June 25.
“Some of these guys have to make some adjustments to their portfolios,” DeSanctis said.
Landing in the largecap index can be a negative for a stock’s price during the reconstitution, according to Ivan Cajic, head of index research at ITG in New York.
Since more money is actually held in smaller names in the Russell 2000 than the Russell 1000, a move to the largecap index generally results in some net selling.
“A little counter-intuitive. It’s a double-edged sword,” Cajic said of a promotion.
Due to the size of the trade and the number of stocks involved, FTSE Russell takes steps to be transparent to market participants regarding their methodology for inclusion while also releasing preliminary lists of stocks that may be affected.
There are no major changes this year, but FTSE Russell has kept in place the rule implemented after last year’s reconstitution that requires new constituents to have at least 5 percent of their voting rights in the hands of public shareholders.
Last year’s July ruling kept Snap Inc from inclusion in Russell indexes, while existing constituents that do not meet the threshold, such as Google parent Alphabet, were given a five-year grace period that expires in September 2022.
“It was pretty quiet on the methodology front. Obviously we had the whole issue with Snap last year and how to deal with voting shares,” said Rolf Agather, managing director of North America research at FTSE Russell in Seattle.
Morgan Stanley anticipates names such as Dropbox, Stitch Fix and Blue Apron to be among those excluded because of the voting rights requirement.
Reporting by Chuck Mikolajczak; Editing by Alden Bentley and Bill Berkrot