New Rules May Impact Russell 1000 Growth Index, Passive Strategies
New weighting rules could make passive strategies less tax-efficient than active ones.
Key Takeaways
To avoid the risk of double taxation, FTSE Russell has instituted capping rules stricter than the IRS 25/5/50 rule.
The changes could increase turnover in passive strategies, making them less tax-efficient than actively managed funds.
Actively managed products may have a clear advantage under this new framework.
FTSE Russell’s New Capping Rules: What’s Changing?
FTSE Russell has updated the individual stock maximum weight limit (capping rule) for constituents of its U.S. equity indexes to ensure compliance with the IRS Regulated Investment Companies (RICs) rule.
The changes are designed to provide better diversification and prevent overconcentration in the largest stocks. However, we believe these adjustments could lead to higher turnover in passively managed funds that closely track those indexes. Those funds could become less tax-efficient than active strategies, which often diverge from their benchmarks.
The new rules are expected to significantly impact the Russell 1000® Growth Index, which includes several mega-cap companies. Because the Magnificent Seven stocks have surged in recent years, they composed more than 55% of the index at the end of 2024.
The recent appreciation in these largest large-cap growth stocks could push some indexes over the IRS’s capping thresholds for mutual funds, ETFs and other RICs.
No single issuer can constitute more than 25% of a RIC’s assets.
Issuers with more than a 5% weight in aggregate can’t sum to more than 50% of a RIC’s assets.
If a RIC exceeds the 25/5/50 limits, it could jeopardize its status as a pass-through entity and face an excise tax levied by the IRS. FTSE Russell’s updated capping framework is intended to reduce this risk.
March 21, 2025: FTSE Russell's New Capping Rules Take Effect
No single company can make up more than 22.5% of any FTSE Russell index.
In aggregate, an index’s largest companies can’t total more than 45% of the index.
Excess weights will be distributed to other stocks in the index.
Going forward, FTSE Russell will rebalance its indexes quarterly to ensure compliance with the new "22.5/45" limits. Figure 1 shows the timeline.
Figure 1 | Important Dates for the New Rebalancing Rules
January 31, 2025 | February 21, 2025 | March 12, 2025 | March 21, 2025 |
|---|---|---|---|
Cutoff date for IPOs and float data. | • Start of query period until March 7. | Date used for prices in weight calculations. | Initial quarterly rebalance. |
Source: FTSE Russell.
FTSE Russell’s capping limits are intentionally set lower than IRS RIC rule thresholds to prevent intra-quarter stock price volatility from triggering a violation of limits.
While the full impact of this index change isn’t yet known, the 22.5/45 rules are expected to affect the composition of the Russell Growth 1000 Index and influence investment strategies benchmarked to it. We recommend our clients review the methodology and potential changes before the March implementation date.
How FTSE Russell’s New Rules Target Overconcentration
Investors may encounter important nuances in how FTSE Russell will apply its new capping rules. Figure 2 shows an example of how the rules would be applied using the Russell 1000 Growth Index weights from Jan. 31, 2024.
Scenario 1
First, FTSE Russell will identify stocks with an index weight above 22.5% and cap those weights at 22.5%. Excess weight is redistributed to the rest of the index constituents.
If that redistribution pushes another stock over the 22.5% limit, the same process occurs. This process continues until no stock has a weight greater than 22.5%. In this example, no companies fell into that category.
Next, FTSE Russell will identify the companies that comprise the top 45% of the index. Companies with weights greater than 4.5% are generally included in this group. The calculation is different for indexes with fewer than 23 companies.
The weights of those largest companies are reduced to bring the total group under the 45% threshold. Excess weights are redistributed to other companies in the index.
As seen in Figure 2, the largest index members total 45.8% of the index, so 80 bps of index weight will be capped and redistributed to names outside this group to reduce the largest companies to a 45% weighting. FTSE Russell calculates this group by adding the index weights of the largest members until reaching an aggregate of 45%.
In this hypothetical case, Apple’s weight in the Russell 1000 Growth Index is reduced from 11.3% to 11.1%, a difference of roughly 20 basis points.
Figure 2 | Applying FTSE Russell’s New Capping Rule
Name | Original Weight | Adjusted Weight | Difference |
|---|---|---|---|
Apple | 11.3% | 11.1% | -0.2% |
Microsoft | 10.3% | 10.1% | -0.2% |
Nvidia | 9.4% | 9.2% | -0.2% |
Amazon | 7.5% | 7.4% | -0.1% |
Alphabet | 7.3% | 7.2% | -0.1% |
Total | 45.8% | 45.0% | -0.8% |
For illustrative purposes only. The table is a hypothetical example of the impact of applying FTSE Russell’s new capping rules based on the Russell 1000 Growth Index as of January 31, 2025. Some numbers may be rounded.
Small Changes May Lead to Larger Shifts in Index Weights
A minor change in a stock’s price could have an outsized impact on the capping process.
Scenario 2
Consider a different hypothetical scenario where Meta Platforms performs better and is included in the group of large index members. Let's say the other large companies total 44.9% in this case. With Meta’s 5% weight, its total weight rises to 50%.
This means that nearly 500 bps would be capped and redistributed. This would require a much larger adjustment across the entire benchmark compared to Scenario 1, where 80 bps were redistributed.
In Scenario 1, Apple’s weight would be adjusted by 20 bps, and in Scenario 2, it would be reduced by 160 bps.
Timing Could Also Play a Role
FTSE Russell plans to review caps every March, June, September and December. It will base caps on prices from the Wednesday before the second Friday in March, September and December. It will use shares’ floating numbers from the Monday following the third Friday.
In June, capping will use prices from the Wednesday before the second to the fourth Friday of that month and shares floating as of the reconstitution’s effective date.
FTSE Russell will announce changes to an index’s weights about one to two weeks before they take effect, which doesn’t allow much time for weight adjustments in active investment strategies.
Evaluating the Impact of FTSE Russell’s Updated Rules
Based on the magnitude of individual stock price changes, the capping process may create additional turnover in FTSE Russell indexes each quarter.
We believe the largest change in weights will occur during the inaugural March capping event.
Passive mutual funds that closely follow indexes such as the Russell 1000 Growth may become less tax-efficient due to higher turnover.
Actively managed strategies may be less vulnerable to the potential risk of higher turnover.
That’s partly because of a distinction in the IRS RIC rules. A stock is only counted in the 5% bucket if the position at the time of purchase increased the weight above 5%. If market appreciation pushes a stock’s weight above the 5% limit, that position isn’t included in the 50% IRS RIC rule limit.
An active fund can maintain larger positions in higher-performing companies, even when using an index as a benchmark. This contrasts with passively managed, index-dependent funds, which can’t.
Active funds can also employ risk management strategies to guard against the downside of higher concentrations.
In our view, actively managed funds may provide an advantage in terms of performance and diversification.
Authors
References to specific securities are for illustrative purposes only and are not intended as recommendations to purchase or sell securities. Opinions and estimates offered constitute our judgment and, along with other portfolio data, are subject to change without notice.
Diversification does not assure a profit nor does it protect against loss of principal.
The opinions expressed are those of American Century Investments (or the portfolio manager) and are no guarantee of the future performance of any American Century Investments' portfolio. This material has been prepared for educational purposes only. It is not intended to provide, and should not be relied upon for, investment, accounting, legal or tax advice.
This material has been prepared for educational purposes only. It is not intended to provide, and should not be relied upon for, investment, accounting, legal or tax advice.