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Investors used derivatives based on the Russell indexes more than ever in adjusting their portfolios to the 2003 reconstitution of the indexes. They did so because the growing number of derivative instruments based on the indexes provided them with more tools with which to control their risks and lower their costs. As a result, they appear ready to use them even more in the future. These tools, combined with other improvements in techniques for managing the transition to the new index, will lead to better results for investors and more efficient capital markets. This paper looks at the strategies that investors have used or considered using in managing the reconstitution process.
'Unlike other economic systems, the capitalist system is geared to incessant change …'
Joseph Schumpeter, "Capitalism, Socialism and Democracy"
The Russell indexes strive to accurately represent what is going on in the U.S. equity marketplace as a whole and within particular subsets of the overall market. Because the nature of companies that exist in a capitalist system is ever changing, as Schumpeter notes, companies come and go, and the indexes need to be reconstituted periodically to maintain their representativeness. Russell has chosen to reconstitute annually, after studying the balance between representativeness and turnover. Russell studies of reconstitution show that more frequent reconstitution increases turnover costs without sufficient improvement in representing the market.
Some index providers have gone to a 'banding' process that reduces turnover at the cost of being less representative and more opaque. A reason Russell's reconstitution has been much studied and is well understood is Russell's objective and transparent set of rules for determining membership. Indeed, many market participants argue that Russell's rules allow those who provide and seek liquidity to find one another more easily. The result is less market disruption than is caused by sporadic surprise announcements of changes.
During the process of changing index membership for any index, much attention is paid to the investors who manage index funds based on the relevant indexes. Russell surveys the passive management community once every six months about their assets under management in the Russell indexes. Below are the results of this survey for June 30, 2003.
This survey may not include all such assets. In particular, we are not sure that we have identified all of the internally managed Russell index funds. However, many investors find it useful to look at these numbers to analyze the size of the trades that are likely to take place over the reconstitution process.