The upcoming annual Russell reconstitution is undoubtedly a frequent topic of conversation and concern for smaller public banks. For these institutions and potentially many others, recent regulatory updates provide a viable alternative.
On an annual basis, a team at FTSE Russell evaluates the composition of their indices and rebalances the portfolio of the top 3,000 companies. This “annual reconstitution” can produce an unfortunate side effect: smaller companies on the lower end of an index’s minimum market capitalization threshold may find that they no longer qualify for inclusion when the threshold increases. These firms can experience a semi-annual whipsaw — sometimes they make the cut, other times they don’t.
When a company is removed from “The Russell,” index fund managers no longer hold shares in that company. In fact, a Russell Index mutual fund manager would be in violation of several rules from the Securities and Exchange Commission if they trade in a ticker that no longer included in an index that they market themselves as tracking.
In simplest terms, when a company is bounced from the Russell, it’s bounced from the $11 trillion pool of index-fund portfolios. For smaller companies that tend to be otherwise thinly traded, this can be a major problem. Many banks that were removed from the Russell at the last re-balance saw a decrease of 30% in their stock, virtually overnight.
The One-Two Punch
Russell indices have a long list of securities they exclude. It is probably easier for most people to think of the composition of Russell’s US-based indices as including only public securities that are “listed” on an exchange, like the New York Stock Exchange and Nasdaq.
Maintaining an exchange listing can be a major ongoing commitment of a firm’s time and money. U.S. exchange listing fees are based on a bank’s market capitalization and total shares outstanding; listing additional shares and corporate actions incur added costs for banks.
So what happens when a listed company gets bounced from the Russell? Share prices drop because index funds begin selling positions en masse, and liquidity dries up as index funds buyers disappear. But the firm remains listed on the exchange, footing the bill for the related ongoing compliance overhead or face a de-listing. In turn, the firm ends up incurring all of the costs and reaps none of the benefits.
Where to go from here?
Some estimates suggest that the minimum qualification criteria for some of Russell’s most popular indices will increase the minimum market cap from $250 million to about $299 million. For banks, this generally means over $2 billion in assets. This is an unfortunate fate for listed banks that may find themselves in the crosshairs; for dozens of others, it may mean further postponing plans for an IPO.
But an alternative does exist that smaller banks can uniquely benefit from. Recent overhauling of SEC Rule 15c2-11 positions the OTCQX Market as a regulated public market solution for U.S. regional and community banks. The market provides a cost-effective alternative that leverages bank regulatory reporting standards and can save banks around $500,000 a year compared to listing on an exchange.
Many of the banks that trade on OTCQX are under $350 million in market cap and can choose to provide liquidity for their shareholders through a network of recognized broker-dealers and market makers.
One key takeaway for management teams is that unless an institution can qualify for inclusion in the Russell and grow rapidly enough to keep up with annual reconstitutions, it may be time for them to re-evaluate the value of trading on listed exchanges.
People often think about the Herfindahl-Hirschman Index (HHI) in relation to its effect on large, public transactions. However, as smaller community banks look to merge with other small banks in their markets or in adjacent communities, the HHI is increasingly becoming an issue. This often overlooked component of a merger could cause significant regulatory impacts on the structure and success of a transaction. For example, one small community bank recently had to withdraw from a bid process because of insurmountable HHI concerns cited by the federal regulators.