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Note: Unless otherwise specified, currency amounts described in this article are in U.S. dollars, and government references are to the U.S. government. The Russell Running of the Bulls: Ideas for Finding Stocks Amit Dugar CFA, Director, Senior Equity Researcher, Schwab Equity Ratings®, Schwab Center for Financial Research March 24, 2011 Key Points
If you're a stock investor who continuously buys and sells small-cap stocks as part of your portfolio, there's an annual event in the investing world reminiscent of the running of the bulls in Pamplona, Spain. It's the yearly reconstitution of the Russell Investment Group indexes. Every June, Russell rebalances its stock indexes: Their analysts identify stocks whose market capitalizations are too small relative to other eligible stocks not currently in the specific Russell index and replace them. Like getting in front of the bulls, many investors try to buy stocks not currently in the Russell 2000 Index that are likely to be added before exchange-traded funds (ETFs) and index mutual funds have to buy those stocks. Why would you want to buy a stock right before it's added to an index? Simple supply and demand. When a stock is part of an index, index funds and exchange-traded funds (ETFs) tracking that index hold that stock. So when a stock is first added to an index, there's usually a rush of demand from ETFs and index funds to buy the stock, causing its price to rise. The problem is you can get trampled along the way. We'll show you how to try to make the most of this seasonal happening—and minimize risk. Some additional words of caution: Although one can make a reasonable estimation as to what new stocks might be selected for the Russell 2000 Index, it's impossible to know ahead of time all the new stocks that will be added. Also, the new stocks that are added tend to be smaller in market capitalization and may be more illiquid in their trading. Don't get trampled Like running with Pamplona's bulls, it's not so easy to stay in front of the herd. Russell Investments telegraphs its new additions in advance via the firm's website after the market's close (usually) on the second Friday in June. Thus, everyone gets the information at the same time. Those lists will be based on the stocks' market capitalizations at the close of the last trading day in May. Thus, the index effect gets diluted because the indexing information gets priced into the stock well before the rebalancing occurs. For the past 30-plus years, new additions to the Russell 2000 Index that are not former large-cap stocks and have fallen from the Russell 1000 have significantly outperformed the average index member in the period before being added to the index. Most of that excess return came in the May through June time period. That excess return has been shrinking in recent years, as hedge funds, institutional investors and active small-cap managers have been playing the same event, as well as the structural changes made by Russell Investments. (In 2005, one of those structural changes was to include eligible Initial Public Offerings [IPOs] quarterly instead of annually.) Due to the increased interest in the rebalancing event, the excess returns have shifted to the April through May period. And the bounce from the Russell rebalancing is short-lived, because stocks added to the index often experience a reversal in July. Look beyond the short term Buying a stock just because it may be added to an index is a highly speculative move. Seeking short-term gains with high risk can provide a thrill—like running with the bulls. But while it may be a short-lived, high-adrenaline rush, it's not necessarily the best thing for your portfolio in the long term. Every year, hundreds of new stocks are added to the Russell 2000 Index due to the rebalancing. To narrow the list of stocks to consider, we suggest concentrating your further research on potential index additions that are also rated A or B on Schwab Equity Ratings. Schwab research has shown that A- and B-rated stocks that are not in any Russell index, but are large enough to be added to one, have had higher returns and lower volatility historically than the rest of the pool of stocks eligible to be added to the Russell indexes. But even if A- and B-rated small-cap stocks don't get into the index, we still think they're likely to outperform. Simply put, we believe a high Schwab Equity Rating provides a better reason to own a stock. If that stock gets into the index, consider it a potential bonus. If you're a short-term trader, you might want to only take advantage of the Russell rebalancing by buying around the end of March and selling near the end of June. This year, the rebalancing will be on June 24. If you're a longer term investor, the rebalancing might be a great time to pick small-cap A- and B-rated stocks that are also potential index additions. And then use the Schwab Equity Ratings guidance to sell the stocks if their ratings fall to D-rated or worse. Essentially, the Ratings provide a 12-month outlook on a stock versus counting on a one-time event, and although past performance is no guarantee of future results, the returns of stocks rated A or B historically have been better, with lower risk (volatility), than returns for the average small-cap stock. Comparing Schwab Equity Ratings and Russell
Source: The Schwab Center for Financial Research, as of February 15, 2011. Tilt the odds in your favor Still interested in trying to ride the short-term small-cap bounce? We believe using Schwab Equity Ratings can tilt the odds that your picks will also be long-term performers. Here's one possible approach to creating a screen that identified potential Russell 2000 additions with the Schwab Stock Screener.
 Source: The Schwab Center for Financial Research
 Source: The Schwab Center for Financial Research
Note: There's one company that passes this screen (COGO) that most likely will not be added to because it lists different countries for its incorporation and its headquarters. With this type of strategy, you can try to improve the odds of finding small-caps for the long-term—and not get trampled by the herd. Buying stocks likely to be added to the Russell 2000 (small-cap) Index is a rare opportunity for you to buy a stock before others do. However, there is no guarantee that the stock price will increase. Important Disclosures Past performance is no guarantee of future results. Supporting documentation for any claims and statistical information is available upon request. The Russell 2000® Index and Russell 1000® Index are trademarks of Russell Investments. Schwab Equity Ratings use a scale of A, B, C, D and F and are assigned to approximately 3,000 stocks headquartered in the United States and certain foreign nations where companies typically locate or incorporate for operational or tax reasons. Schwab's outlook is that A-rated stocks, on average, will strongly outperform, and F-rated stocks, on average, will strongly underperform the equities market during the next 12 months. Schwab Equity Ratings and the general buy/hold/sell guidance are not personal recommendations for any particular investor or client and do not take into account the financial, investment or other objectives or needs of, and may not be suitable for, any particular investor or client. Investors and clients should consider Schwab Equity Ratings as only a single factor in making their investment decision while taking into account the current market environment. The information provided is for general informational purposes only and should not be considered as an individualized recommendation or personalized investment advice. The investment strategies mentioned here may not be suitable for everyone. Each investor needs to review an investment strategy for his or her own particular situation before making any investment decision. All expressions of opinion are subject to change without notice in reaction to shifting market conditions. Examples provided are for illustrative purposes only and not intended to be reflective of results you can expect to achieve. (0311-2072) Return to Top |
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