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Friday's trading volume is one eye-popping statistic that will capture folks' attention this weekend. Many top investors focus on volume as a conviction tool. Of course, there are exceptions, but generally, if stocks are rising on higher than normal volume, it's bullish and if they're falling on high volume, it's bearish.

On Friday, the volume was seismic. But it comes with a big caveat, so investors should take the news with a big grain of salt. The volume spike was because of the annual reconstitution of the Russell 2000 and Russell 1000 indexes, which are tracked by about $2 trillion in passively-managed money, including popular index ETFs, such as iShares Russell 2000 ETF  (IWM) , with $51.7 billion in assets, and iShares Russell 1000 ETF  (IWB) , with $26 billion in assets.

How big a deal is Russell's reconstitution?

The Russell has reconstituted itself annually in June since 1989, and reconstitution is often the heaviest volume trading day of the year. Therefore, Friday's surging volume isn't special. Instead, it reflects a flurry of buy-and-sell orders, usually near the closing bell, from funds mandated by their prospectus to match the index's stock holdings and portfolio weights.

Over the past five years, the average value traded at the closing bell on reconstitution day totals $119 billion. Last year, the value totaled $186 billion. That's a lot of money changing hands in a relatively short period.

Fortunately, funds tracking the Russell aren't surprised by the reconstitution. Russell's been communicating changes to its indexes on its website for a month, and the decisions are based on data from May 6. In addition, specific additions and deletions news has been communicated weekly to stakeholders since Jun 3, so funds have had time to plan moves.

In "The Highest Volume Day of the Year Is on Tap as Indexes Rebalance," Real Money's James DePorre writes:

“Brokers don't just buy a huge block of stock at the close. They have been accumulating the necessary shares for weeks and may employ complex options strategies so that they don't have big losses when they make the final transfer to the index funds at the close on Friday.”

How Russell reconstitution works

The entire U.S. equity market is re-ranked by size, and stocks get placed into two buckets, Russell 1000 large-cap, and Russell 2000 small-cap. This year, the cut-off between the two indexes is $4.6 billion, down from a record $5.2 billion last year. A 5% band is applied to that cut-off to limit last-minute surprise additions and deletions. If a stock's market cap is within the band, it stays in whatever index it was in previously.

This year's reconstitution impacts hundreds of stocks. As of early this week, 308 stocks are joining the Russell 2000, while 315 are departing, with most of those departing heading to Russell's microcap index. In addition, 19 IPOs are being added to the indexes.

Generally, stocks joining the index benefit from passive funds buying stakes for the first time, while departing stocks face headwinds because fewer dollars passively track Russell's microcap index.

The rally in energy stocks this year means that sector is home to the largest number of stocks graduating from the Russell 2000 to the Russell 1000. Interestingly, because the Russell 2000 is more diversified, the energy sector weight in that index will decline by 1.5%. Since more money tracks the Russell 2000 than the Russell 1000, reconstitution could be another reason energy stocks underperformed this week. To a lesser extent, a similar situation exists for consumer discretionary stocks. Its weight is falling by 0.50%.

Does it matter to investors?

It certainly mattered this week, but the volume spike shouldn't add or detract conviction on broader market direction from here.

Back to DePorre:

“All of this buying and selling has nothing to do with fundamentals or technical patterns, but typically market players like to believe this movement is meaningful and can be extrapolated to indicate some sort of trend. It is fascinating to see all the huge blocks transfer at the close, but they don't tell us very much about where stocks are heading in the future. It is possible to catch some increased volatility today, but no systematic way in which to do so.”

The Smart Play

Russell's changes can cause tactical decisions by actively managed funds that rely on industry weights to shadow index their funds (many managers try to match index weights, then tilt above or below them, or use individual stock selection within sectors to generate an excess return).

About $12.6 trillion in assets are benchmarked against Russell's indexes. So, reverberations could impact leadership. If you're curious about historical sector weights in the Russell 2000, you can view them here. We should have updated sector weight insight next week, but the most heavily weighted sectors leading up to Friday were healthcare, financials, and industrials.

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Since the market's move this week may have been impacted by front-running reconstitution day, investors will want to see what happens once trades settle. That will give us a better idea of whether the recent action is sustainable or short-lived.

Friday's trading volume is one eye-popping statistic that will capture folks' attention this weekend. Many top investors focus on volume as a conviction tool. Of course, there are exceptions, but generally, if stocks are rising on higher than normal volume, it's bullish and if they're falling on high volume, it's bearish.

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