Annual readjustment of Russell 3000 offers an important lesson

Your Money

June 27, 2006|By CHARLES JAFFE | CHARLES JAFFE,MARKETWATCH

This Friday, more than 230 stocks will get kicked out of the Russell 3000 index to make room for the same number of newcomers.

If Russell was running an investment portfolio instead of an index, this out-with-the-old, in-with-the-new change would be filled with emotion, passion and sentiment.

Instead, it serves as a good platform for answering an age-old question: Should you let winners run, or rebalance a portfolio periodically to stay true to your asset allocation? Fund investors will find it strange that an index can provide a lesson in active portfolio management decision-making, but it's a byproduct of the index process that most consumers never see and don't notice.

While the Russell swap-out is a bit below average for the last decade - when more than 430 stocks turned over in a typical year - it's the exercise of resetting the index that is worth examining.

The broad-market Russell 3000 is designed to represent the largest U.S. companies by market capitalization; the largest 1,000 companies in the ranking make up the Russell 1,000 (large-cap stocks) and the rest become the small-cap Russell 2000. Combined, they represent roughly 98 percent of the domestic equity market.

Every year, some companies grow into the ranking of the 3,000 largest - there are 122 initial public offerings making the list this year - and others fall out. The large- and small-cap Russell indexes are repositioned accordingly, and the revised list of stocks that make up each will be out next Monday.

The process of rebuilding the indexes - and especially repositioning the small- and large-cap components - makes the Russell benchmarks different from many others. A lot of flashy, small-cap names that have put up impressive growth numbers will graduate to the large-cap ranks, while some sluggish performers will fall down or out of the rankings altogether.

"We're dispassionate about it, just following the rules," says Kelly Haughton, strategic director for the Russell indexes. "It's kind of like spring cleaning or regular maintenance."

But the point of that maintenance is that it keeps the index representing the segment of the market it is supposed to benchmark. There's no market timing in the process; there are times when the changes do tilt the index toward what has been hot because those businesses are growing faster than some others.

The Russell changes, for example, tip the broad index composition a bit more toward consumer discretionary companies, and a tad away from financial services, but that's not about pursuing hot companies so much as reflecting what the stock market is showing.

Likewise, investors should consider rebalancing a portfolio periodically so that it continues to stay on target.

Rebalancing involves culling winners and shifting some of the proceeds to segments that have grown more slowly or lost ground.

Keeping the example simple, let's assume an investor has $10,000 invested, split equally between a broad market index fund and a general-purpose bond fund. If, over the course of a year, the stock side is up 15 percent while the bonds are up 5 percent, the portfolio will tilt. After that year, it will no longer be a 50-50 split, but rather 53 percent stocks to 47 percent bonds.

If that trend were to continue long enough, the investor would be off target, heavier than desired in equities, and more vulnerable to a decline in the stock market.

Rebalancing should not be market timing. An investor who intended to keep 5 percent of assets in gold, for example, could have seen the run in gold funds over the last few years make precious metals a much larger-than-intended piece of the pie. Rebalancing at a certain time - rather than when they fear a decline in gold or see opportunity elsewhere - keeps the process unemotional.

For most investors, rebalancing is an annual event, maybe even a once-every-two-years experience.

The Russell situation illustrates why that is; while the investment firm could change the index daily to stay perfectly on point, that kind of constant tweaking would defeat the purpose.

An individual investor's asset allocation plan, likewise, doesn't have to be precisely on its targets all the time, so long as it never gets so far away that it represents something different from what the investor intended.

For most investors, the lesson of the Russell indexes is simple: Pick a time to review your portfolio where you decide not only which funds are worth keeping, but also make sure that the portfolio is still following your plan.

Says Haughton: "Having a consistent process is a good thing, whether it is an index or an individual investor. ... You're trying to get the performance you expect over time, and that takes some occasional adjustment but not changes all the time."

jaffe@marketwatch.com

Charles Jaffe writes for MarketWatch. He can be reached by mail at Box 70, Cohasset, MA 02025-0070.

Baltimore Sun Articles
|
|
|
Please note the green-lined linked article text has been applied commercially without any involvement from our newsroom editors, reporters or any other editorial staff.