Small-stock money managers struggling to keep up with the Russell 2000 index thought they might get a break at the end of June.
That's when investors expect Frank Russell Co. to remove highflying Internet stocks such as CMGI Inc., E-Trade Group Inc. and Lycos Inc. from the Russell 2000, the benchmark for measuring small-stock investment performance, because these issues have grown too large.
Some small-stock managers didn't buy the Internet companies because of the risk, so the stocks' rise, which boosted the Russell 2000, made the managers' performance look bad. Getting them out of the index should make the managers look better.
One small problem: Those same Internet shares are now sliding, and if that continues, small-stock money managers won't enjoy the benefit of competing against an index weighed down by the tumbling stocks.
"You don't get the benefit of the crash in relative terms, whereas you had all the cost of not being involved while they were rocketing up," said James Haynie, who manages $575 million in small stocks for Colonial Management Associates Inc. in Boston.
The Russell 2000 this year has returned 4.6 percent, compared with 1.9 percent for the average small-stock fund, according to Lipper Analytical Services Inc.
Many professional investors have shied away from the most speculative Internet stocks, concerned the companies wouldn't produce sustainable profits any time soon. They also worry that the stocks' huge gains stem from day traders, who try to profit through rapid buying and selling.
The average trade of CMGI in the past week was 316 shares, indicating that individuals did most of the trading. The average trade of International Business Machines Corp. was 1,338 shares, a hallmark of institutional investors, who typically trade in blocks of thousands of shares.
The Russell 2000 will lose some of its "dot-com" flavor June 30 when Frank Russell reshuffles the index, removing companies too large to qualify as small stocks.
The firm annually ranks the 3,000 largest U.S. public companies in the Russell 3000 index. The largest third become the Russell 1000 index, the firm's benchmark for large stocks. The remainder make up the Russell 2000.
Although new Internet companies will be added to the small-stock index, they generally will be much smaller than those moving to the Russell 1000. In the Russell indexes, the bigger the company's market value, the greater its impact on the index.
Internet companies now make up about 5.5 percent of the Russell 2000. That should drop to about 1.2 percent after the reshuffle, according Diane Garnick, an equity derivatives strategist at Merrill Lynch & Co.
"This year it's been very difficult to beat the Russell 2000 because it's had a very high Internet exposure," said Scott Billeadeau, manager of the $520 million Nations Small Company Growth Fund. The fund is down 2.7 percent this year.
Frank Russell will release the tentative lineup Friday.
The firm ranks companies in the indexes based on the shares available for trading, or float. Goldman Sachs Group Inc., for example, has a market value of $30.4 billion, though it sold only a 14.8 percent stake in its initial public offering last month. That stake now is worth $4.4 billion, the amount that will be used to determine its weighting in the Russell indexes.
A year ago, when Frank Russell last revised the indexes, the cutoff was $1.4 billion--companies worth more went into the Russell 1000, while those smaller went into the 2000. Now some Russell 2000 companies are much bigger.
CMGI, an Internet venture fund, has a market value of $6.7 billion based on its publicly available shares, while E-Trade's float is worth $6.1 billion.
Two likely additions to the Russell 2000 are Xoom.com Inc., valued at $669 million, and MarketWatch.com Inc., with a float of $392 million. Both went public in the past year.
Even with the recent slump in Internet shares, E-Trade has risen more than seven times since the last Russell revamp, while CMGI is up almost ninefold. This year, SportsLine USA Inc. more than doubled. Online stocks overall soared this year, boosting the Bloomberg U.S. Internet Index of 107 stocks by 52 percent.
Many money managers avoid online brokers, retailers and World Wide Web site operators, which could be vulnerable to price cutting and fickle consumers. They prefer companies that make the nuts and bolts for the Internet.
Haynie owns Macromedia Inc., a profitable maker of software for developing Web sites that more than quadrupled last year and has risen 20 percent this year. Billeadeau owns USinternetworking Inc., which lets customers use business-management software over the Internet. It rose 27 percent since its April initial public offering.
Online stocks gave the Russell 2000 what little pop it enjoyed the past few years. The small-stock index has trailed the large-stock Standard & Poor's 500 index since 1993. Investors have preferred larger companies, thought to benefit most from economic growth. They're also easier to buy and sell without distorting stock prices.
Investors may notice more trading in small stocks in the next few weeks as some money managers try to get ahead of the expected changes in the Russell indexes. Aggressive money managers will sell stocks exiting the Russell indexes and buy those joining, trying to trade ahead of index-fund managers, who must make the same trades when the changes take effect.
Internet stocks in particular may be more active. "This year, for the first time in recent memory, you really do have a big, unusual shift in the weight in the Internet stocks," Haynie said.