Dozens of U.S. community banks could be dropped from the Russell 2000 index during the reconstitution process in June.

Analysts from Stephens Inc., Hovde Group and Keefe Bruyette & Woods estimate that more than 80 community banks could fall below the market capitalization cutoff needed to be part of the Russell 2000 index. Investors and analysts are eyeing the reconstitution event as new entrants have outperformed and drop-outs have lagged in prior years.

"Since the June Russell 2000 Index reconstitution is a major event, it can present challenges for small-cap asset managers and potential arbitrage trade opportunities for others," Hovde analysts wrote in a note. "Based on our preliminary analysis, if reconstitution were to happen today, a sizable amount of community banks would no longer be included in the index."

KBW, Hovde and Stephens analysts all estimated the market capitalization cutoff for the Russell 2000 index would be increased to roughly $245 million from about $95 million. All three analyst groups estimated that more than 80 banks are below that cutoff and could be headed for deletion from the Russell 2000 index. The higher cutoff can be attributed to recent strong small-cap performance, special purpose acquisition company, or SPAC, activity, strong IPO activity and the depressed M&A environment in 2020, according to the Stephens analysts.

Most underperformance and outperformance comes in the final months leading up to the reconstitution, according to the Stephens analysts. Of the financial companies that were added or dropped from the Russell 2000 index between 2016 and 2020, additions outperformed the index by about 18%, while deletions underperformed by about 45% in the nine months leading up to the reconstitution, the Stephens analysts found.

KBW's analysts reported more dramatic moves when looking at 2014 to 2020 performance, estimating that new additions outperformed by 33% on average and deletions underperformed by 51% when looking at price movement from the Aug. 31 in the year prior through to the May ranking day. For financial companies, the movement was a little more modest with additions outperforming 19% and deletions lagging by 36%.

KBW analysts wrote that stocks entering or leaving the index saw the most price movement prior to the "rank day" in May when all eligible securities are ranked by total market capitalization to form the index. Performance between the rank day and the actual reconstitution of the index, which takes place more than a month later, has been inconsistent historically, the analysts wrote.

Analysts at Boenning & Scattergood noted that Ohio-based Middlefield Banc Corp. made for an interesting case study, having been deleted from the index in 2019 only to be added in 2020 and now set for deletion again with a market cap of roughly $140 million. During its deletion in 2019, the bank's stock underperformed the NASDAQ Bank Index in the three months prior to reconstitution but outperformed the index afterward. The analysts wrote that price movements from the reconstitution were ultimately "transitory in nature."

Hovde highlighted a few banks as "on the bubble" but likely to remain in the index: Everett, Wash.-based Coastal Financial Corp., Holland, Mich.-based Macatawa Bank Corp. and Southfield, Mich.-based Sterling Bancorp Inc.

Hovde analysts also named several "on the bubble" banks it expects to miss the cutoff: Cerritos, Calif.-based First Choice Bancorp, Rockville, Md.-based Capital Bancorp Inc. and Shippensburg, Pa.-based Orrstown Financial Services Inc.

The Stephens analysts expect only two banks to be added to the Russell 2000 index: Green Bay, Wis.-based Associated Banc-Corp and Charlottesville, Va.-based Blue Ridge Bankshares Inc. The analysts believe Associated Banc-Corp will migrate down from the Russell 1000 index. The cutoff for the Russell 1000 index could be approximately $5.1 billion, the Stephens analysts estimated.

In addition to Associated and Blue Ridge, KBW analysts also tabbed Bank of Hawaii Corp. and First Hawaiian Inc. as new entries to the Russell 2000 after falling out of the Russell 1000.

There is still significant uncertainty around the process given that FTSE Russell will make preliminary lists available on June 4, and the newly reconstituted indexes will take effect after market close on June 25. Hovde analysts wrote that a sell-off prior to reconstitution day made last year's $95 million cutoff unusually low — cutoffs were more than $150 million in the two prior years.

"Anything could happen in the next few months," the Hovde analysts wrote.