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Monday Morning: Index juggling poses task for fund managers

The first quarter is barely over, but already Wall Street is beginning to speculate about the likely changes…

The first quarter is barely over, but already Wall Street is beginning to speculate about the likely changes in the major indexes when they are adjusted for market changes.

The Frank Russell Co. typically reconstitutes its indexes once a year, at the end of June, based on total market capitalization rankings as of the end of May. Standard & Poor’s Corp. typically reconstitutes on an as-needed basis.

Despite the market plunge, especially in the dot-com and technology sectors, this year’s Russell reconstitution is likely to be quieter than last year’s, when 76 new stocks were added to the Russell 1000 Index and 545 to the Russell 2000 Index.

According to an analysis by Merrill Lynch & Co. Inc., only 13 stocks are likely to be added to the Russell 1000 this year, and only 409 are likely to be added to the Russell 2000. That is because there have been fewer new stock issues this year.

Last year, many newly public companies with significant market capitalizations entered the benchmarks and pushed many of the incumbents down or out.

However, the Merrill Lynch analysis suggests that 136 companies will move up from the Russell 2000 Index to the Russell 1000 Index, while 99 stocks will move down from the Russell 1000 to the Russell 2000.

In addition, there will be shifts in weights within the indexes. For example, the weight of information technology stocks in the Russell 1000 will fall by a half percentage point. In the Russell 1000 Growth Index, the technology weighting will fall by 11.5 percentage points, while it will increase by almost 3 percentage points in the Russell 1000 Value Index.

Meanwhile, the weightings of financial stocks will increase by more than 7 percentage points in the Russell Growth index and will decline by almost 3 percentage points in the Russell Value index.

Standard & Poor’s is likely to add at least 13 new stocks to its 500-stock index by the end of the third quarter, according to the Merrill Lynch analysis. That is because at least five mergers of companies in the index are expected to be completed by then, and another S&P company is likely to be acquired by a foreign company. S&P generally drops foreign-owned companies.

An additional 10 companies each weigh less than one-tenth of 1% of the index, and the Merrill analysts expect the S&P index committee to drop at least five of them. Another two may be dropped for other reasons.

Among companies likely to be added, according to Merrill’s analysis, are Genzyme General Corp., Millennium Pharmaceutical and two banking companies – M&T Bank Corp. and Marshall & Ilsley Corp.

Why should anyone care? Because when the indexes are changed, index fund managers have to buy and sell stocks to get their index funds back into line with the underlying indexes. And that raises costs for index fund managers.

“When S&P makes changes in the S&P 500, index fund managers have $1 trillion they have to shift in the new and old stocks, and they have five days to do it,” says Diane Garnick, director of derivatives research at Merrill Lynch. “Index changes are the biggest expenses index fund managers such as BGI [Barclays Global Investors] and Vanguard have.”

And that’s not just because of the trading costs. It’s also because many investors know in advance what the index fund managers are likely to buy or sell, and buy or sell before them. Some stocks run up in price before the index changes are announced. Others decline. The index fund managers have to buy and sell at the worst possible time, immediately after the changes are announced, if they are to stay close to the index.

Savvy individual investors might be able to take advantage of the index fund managers, but that game is probably best left to the professionals. However, if individual investors understand what’s going on, they will not be concerned about unusual volatility in any index stocks they own.

That’s another reason for a financial adviser to talk to clients.

Mike Clowes is the editorial director of InvestmentNews.