Studies suggest that index rebalancing anomalies generate excess risk-adjusted returns caused by stock index funds and institutional investors that benchmark the indexes.
My two-year study from 2017 to 2019 identified these abnormal gains from the annual June rebalancing and shows some profitable strategies.
The best standardized results generated +57.90% in the first six months and the total average gains across the portfolios were highest at +29.04% in the first three months.
My tests support the likelihood of high profitability from known changes in the index that "lead to a 'dramatic increase' in trading volume ratio in the month of June" (Chang et al., 2013).
The Russell Index reconstitution starts again June 7th, and the final index results go live on June 28th for 2019.
Every year the Russell Indexes are rebalanced to bring in new stocks and remove underperforming stocks. The FTSE Russell calls this event the annual reconstitution process, and it begins with evaluations in May and moves to the selection process on June 7th with the newly reconstituted indexes taking effect this year on June 28th.
(Source: FTSE Russell)
This article addresses the key findings from my two-year forwarded tested analysis of reported abnormal effects from the Russell 3000 annual reconstitution from June 2017 through June 2019. My tests looked at whether the top-performing new additions to the Russell Index produced abnormally strong results in the following year. Published financial studies have found that:
Stock additions to the Russell 3000 index lead to a "dramatic increase" in trading volume ratio in the month of June (Chang et al., 2013).
And that the reconstitution event produced measurable effects worth concentrating on in future studies.
Measurable price effects of the Russell 3000 annual index reconstitution have been documented for both stock additions and deletions (Chang, Hong, & Liskovich, 2013)
Historical Performance of the Russell 2000 (Small-Cap Index)
The data and results from this study cover the period from June 2017 through June 2019 prior to the next reconstitution period.
This informal research study was conducted using three different portfolios from 2017 to 2018 to retest published research and explore new profitable methods to generate gains from the reconstitution event.
In the first test portfolio and the only portfolio for the 2017-2018 year, a one-month formation period was used to observe and rank the highest performing stocks for portfolio selection. Those original 10 stocks with the highest breakout gains from the reconstitution period were:
- Halcon Resources Corp (HK)
- Abeona Therapeutics (ABEO)
- Intrepid Potash (IPI)
- AXT Inc (AXTI)
- Kemet Corp (KEM)
- Warrior Met Coal (HCC)
- Simulations Plus (SLP)
- Resolute Energy Corp (REN)
- Stone Energy Corp (NYSE:TALO)
- Genocea Biosciences (GNCA)
In the first test portfolio for the 2018-2019 year, a one-week formation period with a 10 stock selection portfolio was used again. The idea in this test was to see if forming the portfolio faster (one week vs. one month) would allow for the breakout gains to be captured sooner. The 10 stocks selected for the 2018-2019 Russell anomaly were as follows in descending order of one-week price performance:
- Innovate Biopharmaceuticals (INNT) +59.18%
- Zafgen (ZFGN) +34.91%
- TransEnterix (TRXC) +21.61%
- eGain Corporation (EGAN) +14.43%
- Amyris (AMRS) +14.23%
- CASI Pharmaceuticals (CASI) +13.85%
- Nuverra Environmental Solutions (NYSEMKT:NES) +13.15%
- Town Sports International Holdings (CLUB) +13.39%
- Skyline Champion Corporation (SKY) +11.77%
- Avid Bioservices (CDMO) +11.47%
III. Russell 3000 Anomaly Top 20 stocks for 2018 (One Month Formation) [original article for subscribers only]
In the second test portfolio for the 2018-2019 year, a one-month formation period was conducted to match the original 2017 test portfolio, but with a larger sample size of 20 stocks. Those 20 stocks had some overlap with the 10 stock, one-week formation portfolio for 2018. The 10 stocks selected for the 2018-2019 Russell anomaly were as follows in descending order of one-week price performance:
|Symbol||Company Name||Start Price||1 month gain|
|(NIHD)||NII Holdings, Inc.||6.75||90.68%|
|(ABUS)||Arbutus Biopharma Corporation||11.85||74.26%|
|(CDMO)||Avid Bioservices, Inc.||5.66||60.34%|
|(UUUU)||Energy Fuels Inc.||2.95||43.20%|
|(AMPE)||Ampio Pharmaceuticals, Inc.||3.02||39.81%|
|(PTSI)||P.A.M. Transportation Services, Inc.||58.99||38.51%|
|(SIEB)||Siebert Financial Corp.||13.77||37.01%|
|(NOG)||Northern Oil and Gas, Inc.||3.69||33.21%|
|(HEAR)||Turtle Beach Corporation||28.15||30.44%|
|(ADMA)||ADMA Biologics, Inc.||6.4||30.35%|
|(VTL)||Vital Therapies, Inc.||8.1||24.62%|
|(SMPL)||The Simply Good Foods Company||16.63||24.57%|
|(TNDM)||Tandem Diabetes Care, Inc.||28.57||23.31%|
When the results of each of the three annual test portfolios above were standardized, Winsorized, and compared over incremental monthly periods, some significant results emerged. As depicted on the Russell 2000 yearly chart above, 2017 was a very good year for the index with over 19% gains, while 2018 included very significant declines in the last half of the year. Some of the results of this study may be credited or blamed on broader market conditions, while significant findings still emerged from the returns.
1. The best standardized results generated +57.90% in the first six months using a one-month, 10 stock portfolio selection model as described above.
2. Total average gains across the portfolios was highest in the first three months with gains of +29.04%
3. Changes in each of the three portfolios were minimal or negative to the end of the year after six months of tracking.
It is also noteworthy that 83% of the gains from the Anomaly Picks for 2017 were realized in the first six months of the year. - 2017 Portfolio
These results validate prior research on the price momentum anomaly, considered by many to be the premier financial anomaly in market research. Price momentum theory is based on the well-documented phenomenon, "where stocks with low returns over the last year tend to have low returns for the next few months and stocks with high past returns tend to have high future returns" (Fama & French, 2008, p. 1653).
The informal results of this study bear out my initial theory and show that focusing on the top-performing stocks initially can outperform the total index for the year.
This momentum pricing effect typically consists of increasing momentum stocks that continue to increase, defying prevailing historical averages, so that watching the top 10 stocks post-rebalance period may identify some of the strongest momentum growth candidates. - Henning, 2017
Collectively the average portfolio returns were minimal to the end of the year after six months of tracking.
Russell US Indexes
Russell US Indexes are the leading US equity benchmarks for institutional investors. This broad range of US indexes allow investors to track current and historical market performance by specific size, investment style and other market characteristics.
All Russell US Indexes are subsets of the Russell 3000® Index, which includes the well-known, large-cap Russell 1000® Index and small-cap Russell 2000® Index. The Russell Reconstitution process occurs every June and is explained in additional references and analytics at FTSE Russell.
The Russell US Indexes are designed as the building blocks of a broad range of financial products, such as index tracking funds, derivatives and exchange traded funds, as well as being performance benchmarks.
Gains from the 2017 to 2018 test period were 20% and gains from 2018 to 2019 were -9.21%. A significant amount of the annual returns were driven by the broader market, while the first three months in all the portfolios produced the most positive results.
Picks for 2019 Rebalancing
So what do we buy for large gains in 2019? The FTSE Russell final selections for the 2019 Index Reconstitution have not been released yet. Do you really want me to produce another portfolio for 2019-2020? If the prior strategy from my three test portfolios over the past two years provides reliable future results, here is the best approach:
- Select the top-performing stocks after a one-month observation period prior to formation. Both portfolios that used a one-month formation period significantly outperformed the one-week formation period approach.
- Watch for the best results to occur within the first three months. Market effects tend to dominate and price momentum dissipates after three months.
- Don't expect much effect after six months. The last six months of the year produced no outsized average returns for any of the test portfolios.
- Lastly, recognize that my informal study involved only a small percentage of the stocks added to the Russell 3000 index and only covered a two-year period. Circumstances are always changing.
As members and regular readers of my articles know, this Russell Index Anomaly has been replaced with a new CFO Insider Trading Anomaly study for 2019. I am constantly investigating new approaches to obtain excess returns based on scholarly financial research and proven algorithms. Please consider following my articles for updates on these and other market insights.
I trust these articles examining a very unique financial anomaly greatly benefit your trading results in the years to come!
All the very best to you in your investment decisions!
JD Henning, PhD, MBA, CFE, CAMS
Chang, Y., Hong, H., & Liskovich, I. (2013). Regression Discontinuity and the Price Effects of Stock Market Indexing. doi:10.3386/w19290
Fama, E. F., & French, K. R. (2008). Dissecting Anomalies. The Journal of Finance, 63(4), 1653–1678. doi:10.1111/j.1540-6261.2008.01371.x
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Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.