The biggest event on the indexing calendar is the annual reconstitution of Russell Investments’ flagship Russell 3000E Index, of which the Russell 3000, Russell 2000, Russell 1000 and Russell MicroCap Index are subsets.

While changes to the Dow Jones Industrial Average and S&P 500 make big news, they’re few and far between, largely at the subjective discretion of the indexes’ custodians. You can’t plan for or truly predict the changes. Russell’s change can be seen from a mile away.

And it’s a big deal. With $3.9 trillion in managed assets benchmarked to its U.S. indexes, according to Russell (around $542 billion of that in indexed assets), the activity surrounding the annual reconstitution makes June 30—switchover day—one of the U.S. equity market’s largest trading days of the year. The rebalancing forces the movements of many stocks in and out of indexed portfolios as managers try to get the best price for their shareholders amid a huge amount of trading volume.

Negotiating The Transition

“We do a lot of work, months ahead of time, to anticipate the movement from the small-cap index to the large-cap index and vice versa,” said Greg Savage, managing director of iShares’ portfolio management.

According to BlackRock, iShares’ parent, at the end of March there was $83.9 billion in ETF assets following Russell indexes. And while iShares only sponsors 16 of the 70 ETFs tracking Russell’s U.S. indexes, it holds the lion’s shares of the money, with $74.4 billion in assets under management.

The biggest issue affecting passive funds replicating these indexes is the idea of a “free lunch” for traders and active funds that front-run the reconstitution.

You might assume that graduating from the small-cap Russell 2000 to the large-cap Russell 1000 is a good thing for a company. But from a flows perspective, it’s quite the opposite.

When a stock falls from the large-cap Russell 1000 Index to the small-cap Russell 2000, there can be buying pressure. As the smallest stocks in the large-cap index, they may be excluded from both optimized index and actively managed funds. However, when they move to the small-cap index, they tend to be the largest stocks in the new pool, granting them some of the largest weights in that index. Managers of the small-cap fund could potentially buy a lot more shares than the large-cap fund managers will sell.

Meanwhile, opposing high selling pressure occurs when a stock graduates from the Russell 2000 to the Russell 1000.

Consider Capitol Federal Financial (CFFN), a company with a market cap of $1.9 billion. It currently has a weight of 0.000036 percent in the Russell 1000, after falling more than 35 percent over the past 12 months. Given its low ranking, it will likely drop into the Russell 2000 during the rebalance. But what will be the impact?

Estimates say that $135 billion is benchmarked to Russell 1000-linked index trackers. Given CFFN’s weight, that means these funds own about $4.9 million of the stock. If and when it moves to the Russell 2000, it will become a bigger fish.

Based on current levels, it would represent about 0.15% of the index. With $44.2 billion tied to Russell 2000 trackers, those funds would have to buy $6.6 million of the stock. Much of that can slide over from Russell 1000 funds exiting the position, but given the current numbers, there would be a net $1.7 million purchase taking place at the close on the day of the rebalance. That’s the equivalent to 11% of the stock’s average daily volume—a significant, but not overwhelming buy order. However, mutliply that out over hundreds of stocks, and you get some major market-moving activity.

“Some fund managers want to offset the price movements that they think are part of the front- running,” said Joel Dickson, senior ETF strategist at Vanguard. The Valley Forge, Pa. fund company runs seven ETFs tracking Russell indexes. “However, passive managers don’t want to beat the index. They want to minimize the tracking error with respect to the underlying stocks. So, if the goal of the ETF is to provide exposure to the Russell index with low tracking error, then that is attained by doing all your trades on the day of the reconstitution. That way, the front-running doesn’t matter.”

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