About this time every year, the small-cap benchmark Russell 2000 Index undergoes a reconstitution, and that has fast-money small-cap traders smacking their lips.
Small caps, by dint of their comparatively tiny market values and trading volumes, are more volatile and easy to push around with relatively small bids or asks. And those wide swings in price give nimble traders a chance at fat profits.
Since any indexed mutual fund or exchange-traded fund tracking the Russell 2000 has to automatically buy or sell shares in the added or deleted securities, you can see how front-running the reconstitution — that is, buying or selling ahead of the announcement — could be a lucrative move.
The process of reconstituting the Russell indices (the Russell Global, Russell 3000, Russell 1000, Russell Midcap and Russell Microcap also get rejiggered) is fairly drawn-out. Additions and deletions will be made final June 28 after market close, then published July 1. At that point, the reconstitution goes into effect on the $600 billion in assets tracking the small-cap benchmark.
But that doesn’t mean you — the small-fry retail investor — should try to front-run the Russell 2000 rebalance. You’ll be going into battle against legions of professionals — teams of deeply experienced traders who do this full-time with the best information and analytical capabilities.
You’ll be bringing nail clippers to a bazooka fight. Besides, at this point, the only one getting front-run is you.
Even if you have the capability to plunge into this trade, you missed your chance. The pros were making their bets more than a month ago. That’s because May 31 is the cutoff date for how the Russell indices will be rebalanced. All bets were placed weeks ago. Indeed, historically speaking, trading on the reconstitution of the Russell 2000 earns most of its money in the middle of May, according to research from Credit Suisse.
So even if you’re intrepid or goofy enough to try your hand at this play, you’re a month too late.
As for small-cap investors who just sit tight through the rebalancing every year, you might notice an increase in volatility, but that doesn’t mean it’s all due to the reconstitution of the small-cap index.
The CBOE Russell 2000 Volatility Index (RVX) — a sort of investor fear gauge for small caps — has spiked around now every year for the past five years. But then, the broader market has seen volatility spike, too.
Here’s a five-year chart of the RVX and the CBOE Volatility Index (VIX), which serves as the fear gauge for the S&P 500 (data courtesy of S&P Capital IQ):
The VIX has been spiking annually about this time every year as part of this nettlesome pattern of equity markets entering a spring and summer swoon. And the RVX goes along for the ride. Macro factors, the European debt crisis — take your pick — are responsible for the really epic jumps in volatility during the past half-decade.
The small-cap reconstitution might not help matters, but after taking wider market turmoil into account … well, it’s just shouting into a thunderstorm.
Bottom line: Don’t try to play any additions or deletions to the Russell 2000. It’s a fun trade to contemplate, but you’re going up against the house with even worse odds than usual.
Besides, they closed the book on this bet last month.
As of this writing, Dan Burrows did not hold a position in any of the aforementioned securities.