How Index Rebalancing Will Upset Small-Caps

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The annual rebalancing of the Russell 3,000 has generally been a boon for community bank stocks in recent years, but this year's rebalancing brought bad news for the sector.

Frank Russell Co. released preliminary results of this year's rebalancing Friday, and 56 banks and thrifts fell from the list of stocks included in the index, while only 15 were added.

Given the immense amount of money invested in Russell-related indexes, inclusion -- or exclusion -- makes a big difference to the small, relatively illiquid stocks at the bottom end of the index, where basic economics frequently play a bigger role than financial performance in determining market values.

"Supply and demand in the small-caps is immensely important to price," said Adam Aspes, the director of equity sales at Moors & Cabot Inc. in Boston. "The rebalancing drastically affects pricing, regardless of fundamentals of the companies."

The index's makeup is based on market capitalization, so the effect on banks and thrifts has been almost entirely salutary in recent years. The broad market's tumble took the Russell 3,000's market cap with it. After the June 2000 rebalancing, the smallest company on the index had a market cap of $177.9 million; by June 2003, that number had dropped to $116.6 million.

In the meantime, the market value of many community banks, bolstered by strong financial performance, held steady or rose. The result: A wave of small banks and thrifts swept into the index. Russell added 141 banks and thrifts to the index in 2002 and 2003; only two fell from the list during that time.

That was good news for the sector.

"You've got a significant amount of money in the country that is benchmarked against the Russell 2,000 for small-cap index accounts," said Jeff Davis, an analyst with First Horizon National Corp.'s FTN Midwest Research in Nashville. "For stocks that go in, you've got significant buying."

In fact, Russell estimates the amount of money invested in funds that rely on its indexes at more than $300 billion. Most of that money is in funds that track the Russell 2,000, whose components are the smallest 2,000 companies on the Russell 3,000 list. (A separate index, the Russell 1,000, tracks the rest.)

This year's rebalancing was a stark reversal of the last two years, even though small-cap banks and thrifts performed well in the year that ended May 28, the date Russell uses as its market capitalization benchmark. An SNL Financial LC index of banks with between $500 million and $1 billion of assets -- the asset range most likely to include banks at the bottom of the Russell 3,000 -- increased 15% in that period. A similar SNL index for thrifts increased by the same amount.

But the broad market did even better. The Nasdaq composite index rose 25%, and the Russell 2,000 jumped 29%. Though the final numbers will not be known until July, analysts expect that the market's generally good fortunes over the past year will boost the market capitalization of the smallest Russell 3,000 member to about $170 million -- a 46% increase from last year. …