Russell 1000 Rebalancing May Shake Up ETFs

Russell 1000 Rebalancing May Shake Up ETFs

Super Microcomputer, Microstrategy, Carvana headline a June rebalance.

Reviewed by: Staff
Edited by: Ron Day

It happens at the same time every year, a big event anticipated by many. 

Not Christmas, Thanksgiving or even Memorial Day. The big day for ETF geeks like me is the rebalancing of companies and weightings in the major Russell indexes.  

The 2,000-stock index is a small cap barometer, and the Russell 3000 is about as close as one can get to capturing the “entire market.” In fact, with so many businesses staying private, fewer IPO but continued merger activity, the net-net is that index holding well under the headline number of 3,000 stocks. It has been closer to 2,800 or less lately. Unlike commercial airplanes, all the seats are not filled there.

But the one that catches my eye this year is the Russell 1000, which is captured in two forms. Its traditional capitalization-weighted form through the iShares Russell 1000 ETF (IWB) and the Vanguard Russell 1000 ETF (VONE), and in a form I find much more useful as a market breadth indicator, the equal-weighted version via the Invesco Russell 1000 Equal Weight ETF (EQAL). My rational in spending much more attention to the latter form of the top 1,000 stocks by size in the U.S. stock market is that the S&P 500 is such a market cap “hog” that the next 500 stocks don’t amount to much relatively, in terms of size.  

However, when we take the same 1,000 stocks, it makes it a “fair fight.” By not having 95% of them drowned out by the mega caps atop every major market index (except the Dow 30, by the way), we get a much better indication of how the average stock is doing. This has been a key differentiator in recent years between what the headline indexes do and what many investors experience.  

If your primary equity exposure the past three years has been an ETF like the SPDR S&P 500 Trust ETF (SPY), you experienced an annualized return of 9.8%, above the long-term stock market average return. IWB posted a return of 8.7% per year, so there was about a 1% impact by expanding beyond the mega cap stocks.  

Yet if you owned EQAL, your three-year annualized return was only 1.7%. You read that correctly. The identical set of 1,000 stocks, weighted differently, cost you 7% per year, or more than 20% over the past three years. This reflects an era of historically high returns of cap-weighted indexes versus equal weighted. And it brings us back to the significance of the Russell 1000 index rebalancing, which will occur after the close of trading on June 28.

Super Stocks Joining the Russell 1000 Index

Stocks that have been superstar performers in the Russell 2000 small cap area of the market have now qualified to be in the Russell 1000 index. Those include companies like Super Micro Computer Inc., Microstrategy Inc. and Carvana Co., among a few dozen other changes to the index.

The impact on the markets is potentially significant. That’s because the Russell 2000, already loaded with companies that are large enough to be in the index but whose fundamental strength may be challenged by a wave of debt refinancing next year, now loses some of its “most valuable players.” The Russell 1000 now has those high-flyers, though they won’t have nearly as much impact there as they did in the 2000-stock index. At the same time, since some of those stock tend to correlate with the fate of the market leaders atop the S&P 500, it could make the Russell 1000 more volatile if those big stocks roll over during the next 12 months.

The key here for investors and financial advisors is not the details of the changes in the index, as much as recognizing the importance of understanding how these indexes work, how they are constructed, and how they differ from the pros and cons of active management of a stock portfolio. As noted above, the research is worth it, perhaps to the tune of several percentage points per year in portfolio return. 

Rob Isbitts was an investment advisor for 27 years before selling his practice to focus on ETF research and education. He is based in Weston, Florida. Contact him at  [email protected] and follow him on LinkedIn.