Savvy Trades and Investments

[nsomniyak]

Russell 2000 rebalancing - Well, that was a dud. I did not track all the stocks, but of the 20 or so adds and 20 or so deletions from the Russell 2000 today that I was tracking, only 3 moved more than 21% and 2 of those moved "against" the way you would have thought.

So - why didn't the adds move up sharply and the deletions move down sharply, especially those relatively illiquid stocks where the theoretical amount of buying or selling required was equal to 40 or more days of average volume?

I've done a little digging and I think I know part of the answer. The intent of the index funds is to TRACK the value of the index, However, they can accomplish this in a lot of ways, not just the "brute force" approach entailing buying each and every one of the 2000 stocks in proportion to their value in the index.

Using the figures (all in $MM) from the end of May (not this reconstitution but I am sure the concept holds true), we see:
value of the average stock in the index = 1639
value of the median stock in the index = 713
value of the low stock in the index = 169.
This means the value of the whole index = 2000 * 1639 = 3,362,000, and since the average is far higher than the median it is clear that the stock by stock contribution to the index falls off very quickly.

Even if the bottom 1000 stocks were all equal to the value of the median (the HIGHEST possible value for any of them), they would account for only 21.3% of the index value. If you averaged the minimum and median and took that as a more likely (though still probably high, imho) average value for the bottom 1000 of the 2000, they would account for only 13% of the index value, and the top 1000 account for 87%

Now I make the assumption that the split we see from top half to bottom half can be applied to the bottom half itself, meaning that stocks 501-999 account for 87% of the 13%, or another .87*.13 or 11% of the original value pie.

At this point we have attributed 87%+11% or 98% of the value to the top 1500 stocks. A fund wouldn't need to touch the rest at all and could still track the index within 2% (unless one of the bottom 500 went on a humongous run).

There are some other things that could be done as well. An index fund manager might be able to do an off-market trade, say a prearrangement to buy 500,000 shares from the manager of another, non-index fund at today's close. The index fund gets into and the managed fund gets out of a large position without moving the market.

Further, there are other ways to TRACK the index. From a Morningstar article on index funds that discusses "sampling" http://news.morningstar.com/articlenet/article.aspx?id=651074 we find "...For example, the managers of a fund tracking a small-cap index that includes micro-caps--stocks of very small companies that can be hard to buy--may decide it's not cost-effective to try to own each and every stock in the index. Instead they may employ a technique known as sampling, in which the portfolio is designed to mimic the performance of the hard-to-buy stocks, using similarly behaving liquid stocks in their place.

And from SEC.gov on index funds https://www.sec.gov/answers/indexf.htm "...Some index funds may also use derivatives (such as options or futures) to help achieve their investment objective. Some index funds invest in all of the companies included in an index; other index funds invest in a representative sample of the companies included in an index."

So what does that mean? If 2% wasn't close enough (for an index fund, it isn't), instead of buying the bottom 500 stocks in the example above, the index fund manager could calculate what the weighted average alpha and beta of the required positions in those 500 stocks would be and purchase shares in a single far more liquid stock that had a similar alpha and beta without moving the market at all. In practice they might buy several more liquid stocks so as to also attain an industry allocation similar to the index itself. Obviously, if this works for the bottom 500 it also works to some extent for even larger groups of stocks at the bottom of the index. This approach could reduce the tracking error very quickly without moving individual illiquid stocks.

The SEC note suggests that fund managers can also use derivatives to avoid moving stocks in the market. Undoubtedly they have some very bright people and expensive computing algorithms devoted to this.

Finally, upon reflection, it occurs to me that the index fund manager could use strategies as a way of working his way gradually into positions too illiquid to take all at once.

So - do you want your stock to go into the Russell. Absolutely. It is a mark of achievement and relevance. Stocks moving into the Russell, particularly in a year like this when the market is way up from a year ago, are by definition growing. There are also funds and investors that limit their choices to stocks that qualify. For other than the very illiquid adds, there almost certainly is net buying when a stock is added to the index, and then those shares are effectively out of the float for a year.

However, it is abundantly clear that the index fund managers have numerous effective and absolutely legal ways to avoid being forced to buy large quantities of illiquid stocks, and don't need to use brute force to get in line with the rebalanced indexes.

I had taken 6 positions in anticipation of the rebalanced R2K - 2 straight buys of stocks being added and 4 purchases of puts on stocks being removed. I had focused on some of the relatively illiquid stocks involved. None moved significantly. On the other hand, none have moved significantly against me from when I bought them (around June 9) either. I will be unwinding them over the next week. Digging through the list, I did find one stock that warrants further DD for a straight buy unrelated to rebalancing. I will let you know if that further DD takes me anywhere.