Long-Term Impact of Russell 2000 Index Rebalancing

Abstract

The study reported here examined the long-term impact of Russell 2000 Index rebalancing on portfolio evaluation. A buy-and-hold index portfolio outperformed the annually rebalanced index in the 1979–2004 period by an average of 2.22 percent over one year and 17.29 percent over five years. Although short-term momentum and the poor long-term returns of new issues partially explain these returns, index deletions were found to provide significantly higher factor-adjusted returns than index additions. Some small-capitalization fund managers appear to capture a portion of these benefits. The strongest performing funds enhanced their factor-adjusted returns by an average of 1.45 percent per year by holding index deletions and/or avoiding index additions. Among the weakest performing funds, higher returns from holding index deletions were offset by the poor returns of new issues added to the index. Thus, index methodology may provide a structural incentive for portfolio managers to drift from their benchmarks.

Indices provide a performance benchmark for a specific segment of the market. Although many leading indices were not originally developed as investment strategies, today, index funds are increasingly popular investment vehicles. Index providers compete to offer low-cost, representative portfolios that are easy to implement. Yet, an index is not necessarily a passive benchmark. These portfolios are rebalanced periodically as the characteristics of individual holdings evolve. These changes impose short-term costs on portfolios that mimic the index, but the question of how index reconstitution affects long-term portfolio returns and performance measurement remains largely unanswered.

This study illustrates the effect of rebalancing on long-term index performance and portfolio evaluation. Examining additions and deletions to the small-cap Russell 2000 Index for 1979–2004, we found that a buy-and-hold portfolio significantly outperformed the annually rebalanced index by an average of 2.22 percent over one year and by 17.29 percent over five years.

Part of these excess returns can be explained by strong short-term momentum effects. Stocks with good performance grow too big for a small-cap index and continue to have superior performance after being deleted from the index; stocks with poor performance become small enough to enter the index but continue to generate low returns. We found that in the first year after index rebalancing, the deleted stocks outperformed the added stocks by 67 bps per month.

Poor long-term returns of new issues also contributed to the lower returns of the added stocks. These stocks lagged the deletions portfolio by an average of 42–56 bps per month through the fifth year.

Furthermore, the excess returns cannot be explained by the popular risk factors. Using the four-factor model, we estimated that the stocks deleted from the Russell 2000 outperformed the stocks added to the index by 55 bps per month after controlling for the beta, size, book-to-market, and momentum risks.

We also document that some small-cap mutual fund managers capture a portion of the performance benefits that arise when the index adds and deletes stocks. Holding index deletions and/or avoiding index additions enhanced the risk factor–adjusted returns of the strongest performing funds by an average of 145 bps per year. Among weaker performing funds, the benefits of holding index deletions were offset by the poor returns of new issues added to the index, which the stronger performing funds initially avoid.

Our results suggest that index methodology may provide a structural incentive for portfolio managers to drift from their benchmarks.

We thank Kevin Maloney and Russell/Mellon Analytical Services for providing historical Frank Russell Company index data. We also thank Matt Billett, Jon Garfinkel, Dirk Laschanzky, Erik Lie, Tim Loughran, Jay Wellman, and seminar participants at the University of Iowa for valuable comments.