Why so many banks are getting dropped from the Russell 3000

Bank stocks have bounced back from the depths of the pandemic — they are up about 70% over the past 12 months — but many will not make the cutoff when the Russell 3000 Index updates this month.

Eighty-two banks will be dropped from the index when it raises the cutoff for market capitalization on June 25. That's more than in any year since the start of the Great Recession — only four bank stocks were removed in 2020, seven in 2019 and three in 2018. Not a single bank fell out of the index in 2017 or 2016.

Removal from the index has consequences. Investors in index funds that replicate and hold a broad market index such as the Russell sell off companies that leave the index and buy those that move in. These funds have grown in prominence over the past decade. For those pushed out of the Russell, trading volume often declines, making it more difficult for investors to move in and out of the stock, dampening its appeal.

The index can also affect strategic decisions. Even though few banks are likely to sell or buy another bank to bolster their market caps based on any given year’s Russell rebalancing, it could be the final straw for a small number of banks that had already leaned toward selling, said Jacob Thompson, a managing director of investment banking at SAMCO Capital Markets

“This could be one factor on top of several others — succession, competition, shareholder fatigue — that could convince a bank to sell,” Thompson said.

Several small banks gained inclusion in 2020, when the market cap cutoff was unusually low amid coronavirus fallout, making them vulnerable this time around. With the surge in the cutoff level this year, those small banks and many others were displaced by the recovery in market value among larger companies in several other sectors.

“Banks are up; they just aren’t as hot as other industries,” said Brendan Nosal, an analyst at Piper Sandler. “Definitely an unfortunate year for banks” in the rebalancing.

The Russell 3000 is a commonly used benchmark for mutual funds and exchange-traded funds. Nosal said Russell inclusion is important because “it’s one of the most tracked broad indices” and “there’s a lot of passive money” tied to the index.

Russell 3000 membership is rebalanced each June based on the market capitalization of the 3,000 largest exchange-listed stocks in the United States.

The official cutoff for inclusion this year is a market cap of $257 million — far higher than any year since 2007, before the fallout of the crisis that came into view later that year. The cutoff was $95 million in 2020, when the pandemic temporarily decimated stocks, and hovered in the $150 million range for several years before that, according to Janney data.

The higher cutoff benefits industries that have rebounded from the pandemic and regained or more than offset pandemic hits to market caps.

“Bank stocks have had a pretty good run, especially this year,” Thompson said. “It’s just that they were held back for a while in 2020 with credit quality concerns — caused by the pandemic — and therefore their recovery has trailed other sectors.”

Banks will collectively lose 80 spots within the Russell 3000, with the fallout concentrated on community banks with $1 billion to $2.5 billion of assets. While 82 banks roll out, this is offset slightly by two added to the index: The $3.2 billion-asset Blue Ridge Bancshares in Charlottesville, Virginia, which acquired the former Bay Banks of Virginia earlier this year and roughly doubled in size; and the $1.9 billion-asset Five Star Bancorp in Rancho Cordova, California, which completed its initial public offering just before the cutoff.

That is based on a preliminary list of the stocks that will be added and deleted provided by the FTSE Russell on June 4. The list will be updated on June 18 to correct mistakes before becoming final on June 25. The changes take effect with trading June 28.

While it's seen as bad to fall out of the Russell 3000, banks are still eager to be listed. Blue Ridge President and CEO Brian Plum said Russell inclusion had been “a goal for years.”

In addition to becoming a holding for funds that track the index, it also means Blue Ridge’s shares “have a more liquid and accessible marketplace as a participant in a major U.S. index,” he added. “Moments like these … don’t come along every day.”

Several banks that were pushed out this year declined to comment. The net loss for banks was far more than any other sector. Health care was a distant second with 23 net subtractions.

The consumer discretionary sector, which covers industries such as automobiles and entertainment, saw the highest total number of net additions at 37. Energy, buoyed by a rebound in oil and gas prices, and industrials followed with 14 each.

“The high number of banks up for removal is due to relative outperformance of the rest of the market,” said Feddie Strickland, an analyst with Janney. He noted that the Nasdaq Bank Index traded at around 60% of the price-to-earnings ratio of the S&P 500, versus 85% historically. “This also explains why no banks were removed in 2016 or 2017, when banks were a relative outperformer.”