Rebalanced Indexes: Why They Matter

Last Updated on July 14, 2021

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The Russell U.S. indexes go through an annual rebalancing process (or as the parent FTSE Russell puts it a “reconstitution”) designed to preserve accurate representation of the complicated and always-shifting U.S. equities world. The process often offers an upgrade for stocks, putting specific ticker symbols into the portfolios of staid asset managers who might not otherwise have given them a glance.

The rebalancing, accordingly, is widely anticipated as a market event. This year several “meme stocks” will be affected, as well as the prominence of a famous old-line company trying to make itself hip again, and the beneficiary of a recent SPAC.

The process redefines the breakpoints between large, middle, and small cap issuers. It also revaluates companies to determine where they lie in the investment styles space.

Here’s why this matters:

They Matter to Passive Asset Managers

This all matters a great deal to passive asset managers. They typically have a strategy or mandate that involves following specified indexes. So when FTSE rebalances its indexes, the passive funds rebalance their portfolios, and there is a lot of buying and selling to effectuate that.

They Matter to Arbitrageurs

The rebalanced indexes matter to hedge funds, many of whom specifically look to make their profit to “index arbitrage.” If you anticipate someone else’s mandatory buying you can front-run it with your own. Ben Mezrich, a popular novelist, wrote a book offering a thinly fictionalized account of the excitement created among east Asian hedge funds in 1995 when Hong Kong Telecomm was merging with Pacific Century Cyberworks.

The premise of the Mezrich book is that in the mid ’90s the government of Hong Kong was running a tracker fund for its equivalent of the Dow, the Hang Seng, and that under the charter of the tracker fund it had to buy $225 million worth of PCC stock. This obligation was widely understood, and the particulars of that purchase became the subject of James-Bond level skullduggery.

The Playboy Group Has joined the Russell 200 and the Russell 3000 Indexes
Intriguingly, the PLBY Group (NASDAQ: PLBY), owner of the world-famous “Playboy” IP, has benefitted from the rebalancing as well. It has joined both the Russell 2000 and the Russell 3000 indexes. Pictured here: CEO Ben Kohn, Photo credit:

And They Matter to the Upgraded Companies

Should it matter to you, the retail investor? It might. It certainly matters to the companies that are effectively upgraded by inclusion. It shows that some of the stocks considered rather fringe “meme” plays are becoming mainstream Inc. One such stock, Plug Power Inc., (NASDAQ: PLUG) much discussed on Reddit, made an 88% monthly gain in January 2021 and became the largest contributor to the performance of Russell’s small-cap growth index.

Now, Plug Power — a developer of hydrogen fuel cell systems — has joined the big time. It is on the new large-cap index, the Russell 1000. Also new there: GameStop Corp. (NYSE:GME). GME is perhaps the paradigm of meme stocks.

QuantumScape Corp., (NYSE: QS) which makes batteries for electric cars, represents a close cousin of the meme stocks. It is a forever private “unicorn” that went public in the recent SPAC excitement. And it, too, is newly on the list for the large-cap Russell 1000.

Intriguingly, the PLBY Group (NASDAQ: PLBY), owner of the world-famous “Playboy” IP, has benefitted from the rebalancing as well. It has joined both the Russell 2000 and the Russell 3000 indexes. Playboy was at its peak as a brand in the 1960s-70s. It has suffered a long decline since then, with competition from other “lad mags” on the one hand and with more explicit (cheaper) porn on the other. Quite recently (2020), PLBY has given up on its print operation entirely and turned itself into a digital enterprise under CEO Ben Kohn.

The Russell 2000 inclusion may be considered a tribute to Kohn’s success in the turnaround. PLBY stock began this year below $11. It is now knocking on the door of $40.

What can we say, in general, about the way these memes, these unicorns, and this revival from an earlier pop-cultural era, have all arrived at indexed respectability? Shuli Ren put the point well in a recent Bloomberg column: “[Markets] change, and good indexes need to reflect that. Retail investors are no longer passive players [their viewpoints should be] reflected in broader indexes that aim to capture major characteristics of the marketplace.”

Indeed they should be. And, clearly, they are.