Thanks to unprecedented market volatility, widely followed style indexes published by Russell Investments are expected to look substantially different at the end of the month when the firm's stock indexes are re-balanced.
For example, many financial stocks likely will shift to Russell growth indexes from Russell value indexes when the Tacoma, Wash.-based index publisher comes out with the final reconstruction of its indexes after the close of U.S. markets June 26, said Ronald J. Surz, president of San Clemente, Calif., consulting firm PPCA Inc., who created his own set of style indexes in the mid-1980s.
The earnings of many financial companies have fallen faster than their stock prices, making the stocks appear expensive on a relative basis, he said.
MARKET SNAPSHOT
The annual reconstruction of Russell's indexes started last Friday when Russell took a “market snapshot” for stock price and share data at the market's close.
A preliminary list of the additions and deletions to Russell indexes will be published after the market close June 12, and updates to the list will be made June 19 and 26.
Unprecedented market volatility will probably result in significant movement of financial stocks be-tween style indexes, said Stephen Wood, a senior portfolio analyst with Russell.
Because Russell had yet to take its market snapshot, however, he was leery of talking about specifics.
Russell allocates stocks that have both value and growth characteristics to its indexes on a percentage basis, depending on how strong those characteristics are. As a result, some stocks can appear in both value and growth indexes — an approach that differs from that of Standard & Poor's of New York.
When putting together its style indexes, S&P draws a much harder line that divides stocks into value and growth.
Also, S&P re-balances its domestic style indexes at the end of December and its global indexes at the end of September.
It is partly because of when S&P re-balances its style indexes that its financial stocks didn't move from value to growth. Because of when Russell re-balances its indexes, it will capture this year's rally in financials.
The most dramatic changes to Russell's style indexes are expected to center on financials, but other sectors are also expected to witness significant change.
Energy and health care are set to “slim down” in the small-cap Russell 2000 Growth Index, while consumer staples, financials and information technology should “bulk up,” according to a report from Merrill Lynch & Co. Inc. of New York at the end of April.
“In the Russell 2000 Value [Index], we project utilities and consumer staples will see weight declines, versus rises for energy and industrials,” the report said.
The health care sector should become a larger portion of the large-cap Russell 1000 Growth Index, and industrials are set to shrink, according to the report.
ETFS VERSUS MUTUAL FUNDS
The changes are important to investors because more turnover in the style indexes means potentially more turnover in the mutual funds and exchange traded funds that follow them, said Michael Krause, president of AltaVista Research LLC, a New York-based ETF research firm.
Turnover isn't as much of a problem for ETFs, because of their tax-efficient structure, but a mutual fund forced to sell stocks may create an unwanted capital gains distribution, he said.
Of course, with so many investment losses, capital gains aren't expected to be much of a concern.
Increased turnover, however, can still lead to an increase in front-running, in which investors try to snap up stocks that they think will be included in the index.
“When changes are announced, people rush to buy ahead of the index funds, causing a pop in stocks that are about to switch indexes,” Mr. Krause said.
That can make it more expensive for a fund to buy the stock.
Russell, however, addresses front running by telegraphing changes to its indexes well ahead of its final re-balancing, giving institutional in-vestors the chance to spread their trades over time.
But even if the company didn't do so, Mr. Krause said, he doesn't think that front running would be a big issue this year.
There will be some change, but because everything is beaten down, “I don't know there will be that dramatic of a shift this year,” he said.
E-mail David Hoffman at [email protected].
