An Example of a Passive Selection Family

Frank Russell & Company of Tacoma, Washington, created the Russell family of passively selected stock indexes in 1984. Russell calculates the value of 21 indexes daily. Almost all Russell indexes are subsets of the Russell 3000 Index, which represents approximately 98 percent of the investable free-float U.S. equity market. The one exception is the Russell Micro Cap index, which stretches below the Russell 3000.

The rules for Russell index methodology are listed in the text that follows. Reconstitutions of the indexes are done once a year on June 30, based on market data from May 31. A more in-depth description of their index methodology is available at the Frank Russell & Company web site, which lists the rules for deciding how an index should be categorized using Index Strategy Boxes.

Russell eliminates the following securities in their U.S. equity indexes:

• Stocks that do not trade on a major stock exchange

• Stocks that trade below $1

• Closed-end mutual funds, limited partnerships, royalty trusts

• Berkshire Hathaway, Inc. (considered an investment company)

• Non-U.S. domiciled stocks, foreign stocks, ADRs

The securities left are ranked and separated by size:

Common stocks are listed from the largest to smallest by market capitalization.

• The top 3,000 stocks are included in the Russell 3000 Index.

• The largest 1,000 stocks are included in the Russell 1000 Index.

• The next 2,000 stocks are included in the Russell 2000 Index.

• The smallest 1,000 stocks in the Russell 2000 plus the next 1,000 smallest stocks below the Russell 2000 become the Russell Micro Cap index.

Each Russell index is then divided into style indexes:

• Each stock in the Russell indexes is ranked by price-to-book ratio and its forecasted long-term earnings growth averages.

• Variables are combined to create a composite value score for each stock.

• Stocks are ranked by their score and applied to a mathematical formula to the distribution to determine style membership weights.

• Of the stocks, 70 percent are classified as all value or all growth, and 30 percent are weighted proportionately to both value and growth and are listed in both indexes.

The Russell passive family of indexes is a hierarchy. It is divided into parts and the parts add back up to the whole. The broad market index becomes value and growth indexes, and small stock and large stock indexes. Building back up, those indexes reconnect to form the Russell 3000. Figure 8.2 illustrates the family.

It may not be necessary or feasible for an ETF manager to include all the securities in an index. An ETF manager works around the

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