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Introduction
Each year, the Russell indexes are rebalanced to incorporate new stocks and remove underperforming stocks. The FTSE Russell calls this event the annual reconstitution process. It begins with evaluations and “rankings” in May and moves into transition in June month. For the year 2022, from June 3, the preliminary selection lists will be communicated to the markets. Updates are provided after June 10th, 17th and 24th with the reconstituted indices it will take effect after the close on June 24 of this year.
FTSE Russell
Over the years, I have tested many published academic studies on simulated trading portfolios to measure the excess abnormal returns claimed. These research bonus articles go into much more detail for members of my market service, but samples and summaries of various pre-test results can be read here:
Reconstitution Abnormal Returns Test for 2022
The current multilevel study began from the June replenishment period and has extended through July during the first month of analysis. Most published research finds that the strongest effects of the index anomaly occur between one and three months after reconstitution. I’m taking a moment to share with you some of the results from the first month of the various investigations tested, as summarized below:
1. Cai and Houge (2018) multi-year findings that, over the long term, a Russell 2000 buy/hold portfolio significantly outperforms any new portfolio of additional stocks. They found that a buy-and-hold portfolio significantly outperformed the annually rebalanced index by an average of 2.22 percent over one year and 17.29 percent over five years.
2. Zdorovtsov, Tang, and Onayev (2017) evaluated 14 years of Russell 3000 reconstitution behavior between 2000 and 2013 and observed strong positive post-event returns for index additions. The strongest results were found in the longest measured post-event period of 21 days with value-weighted average gains of +7.46%.
3. More recently, according to Chinco and Sammon (2022), they document that the strongest positive return after the reconstitution comes from stocks that move up in the largest-cap Russell 1000 index since the 2000 index.
Chinco & Sammon (2022)
4. In Madhavan’s (2003) study, he found several return anomalies in the reconstitution data between 1995 and 2001. One element was that the mean return for the month of July for the differentiated portfolio produced negative mean returns of -7% after the reconstitution date. , suggesting a strong mean reversion. In other words, the strong average gains of +6.8% in the long additions/short disposals portfolio in June reverted to -7% in July over their seven-year study.
Current 1 month Russell anomaly results
It is too early to draw conclusions from many of the anomalies published in the financial literature, but the first month’s test results show very strong validation of several documented abnormal returns.
1. The study by Cai and Houge (2018) focused more on 1-year returns and supports my previous research papers that various index anomalies do not usually sustain beyond six months. The Russell 2000 is up +10.75% in a very strong start to July that may later support its research that a 1-year buy/hold approach significantly outperforms portfolios of reconstitution anomalies in long term.
2. The research of Zdorovtsov, Tang, and Onayev (2017) is strongly validated in my current test. The strongest results in their study were found in the longest measured post-event period of 21 days. While they didn’t measure the results for the full month after the event, we can see that of the Russell 2000’s +10.75% gains for July, almost half of the returns, +4.31% were achieved just last week 3. The Chinco & Sammon (2022) study is evaluated in much more detail in a separate section below due to the complexities involved in measuring the Rising 1000 portfolio and the Lowering 2000 portfolio discussed below. The 1 month results are very significant and validate their research in this measured time period.
4. The seven-year study by Madhavan (2003) observed a very strong mean reversion between June/July in the period before the constitution and the month after the event. This effect is extremely clear in 2022, even if we did not apply the exact same portfolio test that was published in the research journal.
FinViz.com
You can review some of the previous June/July mean reversion patterns on this long-term chart and try to extrapolate possible future reversion patterns. The chart may support previous research that most anomalies tend not to persist beyond six months.
FinViz.com
Chinco & Sammon (2022) July results
Chinco & Sammon’s (2022) study found statistically significant results that stocks moving from the Russell 2000 index to the larger-cap Russell 1000 index far outperformed stocks moving in the opposite direction to the index reconstituted
Chinco & Sammon (2022)
Since the 2007 FTSE/Russell bandwidth rule, there has been a significant decrease in the average number of qualified switches from 182 stocks to 66 stocks. By 2022 only 50 stocks migrated between the two indexes. To test the results of Chinco and Sammon’s research I constructed two portfolios of the “Rising 1000 Index Stocks” and the “Running 2000 Index Stocks”. The comparison of the two portfolio results is highly significant for July and clearly validates the published conclusions.
The Z-score test of the two populations different yields for July, provided statistically significant results. The value of z is 2.7221. The p-value is .00652. The result is significant p < 0.05.
The Rising 1000 portfolio had 18 of 21 stocks (85.7%) with positive returns and average July gains of +8.71%. The Lowering 2000 portfolio has 14 of the 29 stocks (48.2%) with positive returns and average July gains of +1.91%.
VMBreakouts.com
You can clearly see from the portfolio tracker how skewed the Lowering 2000 portfolio is compared to the Rising 1000 index portfolio in the table above. These results strongly validate Chinco & Sammon (2022) in the first month of testing. Top performing stocks are reserved for members of my community, but other top performing stocks that should continue to do well include:
conclusion
Many academic research studies have been published on reconstitution anomalies around the FTSE Russell, S&P 500 and other major indices. The annual Russell Index reconstitution process lends itself well to research and in-depth analysis each June. Over the years I have tested many different published claims in a live market environment to see if members of my community can leverage these abnormal returns in their own portfolios. I hope this new research review among many from 2017 provides you with additional insight into your own business!
All the best!
JD Henning, PhD, MBA, CFE, CAMS
References
Cai, J. & Houge, T. (2018). Long-Term Impact of Russell 2000 Index Rebalancing. Long-Term Impact of Russell 2000 Index Rebalancing
Chinco, A. & Sammon, M. (2022). Excess volume on reconstitution day. Available at
Zdorovtsov, V., Tang, O. and Onayev, Z., Predatory Trading Around Russell Reconstitution (2017). Available at
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