Print

On Friday, June 26, the market closed in a flurry of activity caused by the annual rebalancing of Russell Indexes. Not all data has been released, but Russell 3000 had 427 changes, while Russell Microcap had 655. Is this good or bad? And how does that affect your returns?

Stocks are included in the Russell Indexes (1000, 2000, 3000, Microcap, Global) based on market capitalization. This serves as an objective benchmark for measuring performance. If a stock's capitalization drops, it is dropped from the index. If it gains, it is added. That's what the annual rebalancing is all about: dogs get ditched, new kids on the block are added.

There are over a dozen ETFs based on Russell Indexes, with roughly $35B in assets, iShares Russell 1000 Growth (IWF), with over $10B, being the most popular. I am sure there are also mutual funds that use Russell for at least part of their investment strategy. When Russell rebalances, funds based on its indexes have to sell/buy the underlying stocks accordingly by a certain date, causing huge price moves and spikes in volume.

Since most professional money managers fail to outperform the market, keeping your money in a broad-based index fund makes sense. Rebalance once a year by ditching losers and adding winners.

But if you look closer, things don't look so rosy.

A stock may remain in the index for years while its capitalization declines. That means holding a lot of former highflyers on the way down until they finally get dumped after dropping below a threshold. Here are some of this year's deletions:

ACAD (down from $15.38 in October 2007 to $2.08 - 86% loss);

FVE (down from $12.13 in January 2007 to $1.64 - 86% loss);

JSDA (down from $24.59 in April 2007 to $1.07 - 95% loss);

LCAV (down from $47.26 in June 2007 to $4.63 - 90% loss);

ROCK (down from $29.00 in June 2006 to $6.04 - 76% loss);

But the absolute "winner" is:

PEIX (down from $32.34 in April 2007 - 99% loss).

There is no conceivable reason whatsoever to hold these losers through multiyear descent â€Â" except when you are short it.

One may argue that these losers are offset by rising winners. But Russell Indexes cover mostly small cap stocks known for their fast runs. Most are 3-6 months, some as long as a year. They don'tt wait for an annual rebalancing to start moving. By the time a stock gets added in June, the run may be over. So while ditching multiyear losers, you may also be stuffing your portfolio with past winners. This year's prize goes to such additions as AIPC, ATRO, BWEN, CRED, DDRX, and TZOO - former highflyers on their way to deletion:

ATRO - down from $52.69 in October 2007;

BWEN - down from $25.40 in May 2008;

CRED - down from $30.00 in January 2006;

while others (like AIPC and DDRX) may be just over the top.

The above boils down to buying high and selling low - hardly a recipe for superior returns.

There are other problems as well:

It's not all bad though. There were some zoomers added on their way up that stand to benefit from Russell's exposure: CGA, FHCO, HEAT, LZR, LPSN, PVSW, RGR, TIS, to name a few. But why hold 3,000 stocks to get to a dozen potential winners?

Slav Fedorov is a full time stock trader and founder and managing member of TradingZoom, LLC that provides timely stock picks in small cap stocks to part-time traders: http://www.tradingzoom.com/

Slav also offers personolized one-on-one live coaching for beginning stock traders: http://www.liveperson.com/slav-fedorov

Article Source: http://EzineArticles.com/?expert=Slav_Fedorov