Annual Style Index Reconstitution: Good or Bad?

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In just two weeks, at the end of June, the Russell style indexes will undergo their annual reconstitution. A lot has happened in the last year, especially to the finance sector. So here are the pressing questions for financial advisors:

• Is annual reconstitution too frequent or not frequent enough?
• What reality should advisors use to evaluate investment managers? The world as it existed a year ago, before the financial crisis, or the real world today?

  • What alternatives are available to advisors? That is, what is today’s reality?
  • Should following the current reality, thereby creating a tracking error away from the market’s June 2008 style composition, be prized or penalized?

Investment managers can blindly follow the old reality, or they can make big bets away from the indexes, exposing themselves to business risk. It’s an ugly dilemma because the right thing for investors could be the wrong thing for their investment managers. Russell has persuaded the industry to accept a practice that is in the best interests of investment managers rather than their clients – it makes life easier for indexers and index huggers.

In this commentary I contrast contemporaneous performance evaluations to those locked back to June 2008. I examine the past 11 months, through May, 2009, and the first quarter of 2009.    

Using my methodology, the large cap finance sector has been transformed from value to growth. The picture and the table below show what has happened to the 36 stocks that were classified as large company Finance in June 2008.

Large Financial Stocks

This transformation has changed the composition of Surz Style PureSM (SSPSM) indexes, which are reconstituted quarterly. Specifically, the finance allocations changed as follows:

Finance Allocation of SSPsm Then and Now











By not recognizing what has happened in the past 11 months, indexers and index huggers are overweighting finance by 9% in large value, and underweighting finance by 6% in large growth.

The effects of these “bets” can be seen in the performance of style indexes over the past 11 months, as shown in the exhibit on the right. The exhibit also shows the insights that are gained by defining an additional style (core) between value and growth. Both S&P and Russell show growth outperforming value, due in large part to the finance weighting in value. But much of finance has become pure growth, as reflected in the Surz Style PureSM indexes, and pure growth has underperformed pure value using quarterly reconstitutions. Pure growth has suffered from its allocation to finance.

Core and Reconstitution

Also, pure core (between value and growth) has performed closer to pure value than to pure growth, which has implications for managers near the middle of the growth-value style spectrum.

Pure growth managers should be lagging their popular indexes, while pure value managers should be beating their S&P and Russell bogies, where “pure” is defined as tracking the current reality.

Looking at the first quarter of 2009, bets for or against the finance sector had a substantial impact on performance, especially for the core segment of the market.

Read more articles by Ron Surz