October 27, 2022
Every year in June, Russell FTSE “refreshes” their leading index in an event called reconstitution. Reconstitution is a process which helps the Russell 1000, 2000, 3000, and other Russell indexes better reflect the U.S. markets. Once those changes are made, the billions of dollars tracking the indexes start moving.
This year, those changes were made public throughout the month of June. On the morning of June 25, 2021, those changes went live. You might not have even noticed. In fact, this decision might not even directly affect you. However, we decided to illuminate the reasons why reconstitution, or changes to major indexes, have become market-wide events. We’ve also broken down some of the pressing highlights from the 2021 reconstitution of these indexes:
What is reconstitution and why does it matter?
If you’ve never heard the word reconstitution before, you’re probably not alone. If it helps you, it might be wise to replace the word reconstitution with refresh. That’s because the reconstitution process is a refresh to indexes. However, this kind of refresh is not like going to Ikea to buy some new furniture. It’s a meticulous, detail-oriented process that brings about changes which affect the entire market.
If you’re not familiar with indexes and their importance, we have an entire article dedicated to the biggest indexes in the US and how they work. But, if you’re looking for the sparknotes: changes to indexes are not made arbitrarily and they’re not taken lightly. These changes involve a process that rebalances and reweights the holdings in an index. It also involves adding and deleting certain constituents from an index. The goal with reconstitution is to make an index better reflect its goal or expected outcome.
In the case of the Russell indexes, the changes are made based on the market capitalization of companies. Russell FTSE is on a mission to rank every company by its size. The 1,000 biggest companies in America are at the top of that list and become members of the large-cap Russell 1000 index. The next 2,000 largest companies (that’s to say, companies ranked 1,000 to 3,000) go in the Russell 2000. And, all of those constituents are members of the market-tracking Russell 3000 index.
So, why reconstitution? Well, because markets change. Some companies are bigger this year (and should rise on this hypothetical “leaderboard” of stocks) and others are smaller (which means they should fall in the index or be removed to let bigger companies take their place.)
How does reconstitution affect the market?
Reconstitution is an event which moves markets for many reasons. For one, reconstitution can cause volatility in markets. ETFs and mutual funds tracking indexes might be made to sell or buy large amounts of stock in order to bring their product into balance with the updated index.
Another factor is the money moves in individual stocks. Imagine that you’re going to go surfing for the weekend. Now, imagine that you can predict every good wave. Wouldn’t you want to get ahead of it? In this analogy, surfing is active trading. Every “good wave” in the surfing world is likened to a giant wave of money that moves throughout the market during reconstitution. If a large index announces it will add a specific stock, it is likely that it will go up (because ETFs and mutual funds tracking that index will have to buy it). If a company is removed from an index, it will likely cause a drop in the stock’s price or volume.
Now that you understand that reconstitution causes market-wide volatility and stock-specific volatility, you can understand why this “refresh” stuff is no walk in the park. It is very serious business and the changes affect all people involved in markets.
Once reconstitution has concluded, the impact continues. The newly-refreshed index, and all of the many financial products that track it, will have new and reweighted constituents. In the case that there are substantial enough changes, the weighting of certain companies can affect the success of the index. This means that reconstitution ultimately boils down to affect all of the money tracking indexes. Why? Well, because it’s ultimately somebody’s money that is being put to work in these stocks at the end of the day.
Tesla in the S&P 500: A case study
Tesla being added to the S&P 500 in December 2020 is an excellent example of how reconstitution can affect markets at scale. The news broke that Tesla would be added to America’s biggest index on November 16, 2020. At the time, Tesla was a $500 billion company. However, the company was not added to the index immediately. Instead, the selection committee indicated that the automaker would be added to the index on December 21, 2020.
Between November 30 and December 21, the stock rose 59% as investors jumped on the opportunity. That 59% was part of a larger run up in the stock that had taken place throughout 2020. The company was up 640% from the start of the year to its listing in December. Since it’s listing, Tesla is up just 4.7%. That lags the broader market: the S&P 500 was up 16.1% over the same period of time. So in short, reconstitution decisions can leave American investors as the bagholders. However, these decisions are made intentionally to reflect the market.
By the numbers: Changes to the Russell indexes in 2021
As is the case with every year’s Russell reconstitution, thousands of companies will leapfrog or drop based on their market capitalization (the value of the company.) Hundreds of companies will be added or dropped from the index. And, naturally, only a handful of changes will become newsworthy or relevant.
There are a few big numbers from this year’s reconstitution. The first you should know is $257.1 million. That is the market capitalization of the smallest company in the Russell 2000 (and consequently, the Russell 3000). Any companies that fell below that threshold were deleted and replaced with larger companies. This “minimum requirement” for membership has risen 171.2% year-over-year.
There are 56 companies joining the Russell 1000 this year. 30 of those companies are graduating from the Russell 2000 to the large-cap index. Many of them are stocks that have appreciated great popularity among retail investors such as GameStop, Caesars Entertainment, and Novavax. The remaining companies are IPOs or “new listings” in the Russell US Indexes universe such as Snowflake, DoorDash, and DraftKings.
45 companies have fallen out of the Russell 1000. This is because the “minimum requirements” to join the Russell 1000 have risen, much like the requirements to join the Russell 2000 and 3000 have also risen. In order to stay in the Russell 1000, you needed to have a market capitalization of at least $5.2 billion. That means the barrier to entry rose 73.3% year-over-year.
The small-cap Russell 2000 added 271 companies, which includes the 45 companies coming from the Russell 1000. The remaining listings are IPOs and new listings to the Russell US Indexes universe.
AMC Entertainment will remain one of the largest constituents (if not the largest) of the Russell 2000. Unsurprisingly, many stocks popular with retail investors found a new home in the Russell 2000/3000. Among them are Palantir Technologies, Clover Health, Bed Bath & Beyond, Workhorse, Nikola Corporation, Marathon Digital Holdings, FuboTV, and more.
Many of the most notable additions to the Russell indexes come from the healthcare and consumer discretionary sector. For more insight on sectors and how they fit into the broader picture of the markets, read our article on sectors.
If you’re looking for more information on Russell FTSE’s 2021 reconstitution, you can check out their website that breaks down the process.