LSE in talks to buy Russell to expand in U.S. stock indices

* In talks with Northwest Mutual to buy Russell Investments

* Russell's indices business could fetch over $2 billion

* LSE says any deal would be part funded by rights issue

* LSE shares fall 2.5 percent (Adds analyst comment, background, shares)

By Freya Berry and Clare Hutchison

LONDON, May 13 (Reuters) - The London Stock Exchange (LSE) is in talks to buy Seattle-based Russell Investments in a deal that would expand its stock index business in the United States, the world's largest equities trading market.

The LSE, which owns FTSE International financial indices, said on Tuesday any deal would be part funded by selling new stock to its existing shareholders.

Analysts estimate Russell Investments, which owns the Russell 1000 Global Index for stocks, could fetch over $3 billion. However, they think the LSE would only be interested in its indices business, and not its asset management arm, which could cut the potential price tag by around $1 billion.

"They (the LSE) are improving their footprint in the U.S. and this would be a challenge to MSCI (NYSE: MSCI - news) ," said Espirito Santo Investment Bank analyst Phil Dobbin, referring to U.S. index provider MSCI, which is also interested in Russell.

Rather than making choices on individual stocks, large investors often track indices such as those compiled by Russell and the LSE. Russell's indices have $5.2 trillion in assets benchmarked to them, while its asset management arm has $259.7 billion in assets.

Life insurer Northwestern Mutual, which currently owns Russell Investments, started exploring a sale of the unit in January after deciding it was not a core part of its business.

Sources familiar with the matter told Reuters last month that Canadian Imperial Bank of Commerce (NYSE: CM - news) , MSCI and several private equity houses were considering bids for Russell.

"Russell fits with the U.S. and their plans to build up their index. I can't see them buying the asset management business," said Numis Securities' analyst James Hamilton of the LSE's interest in Russell Investments.

"Whether it's a good deal or not depends on price."

LSE shares were down 2.5 percent to 1,808 pence at 1235 GMT, the second-biggest decline on the UK's benchmark FTSE-100 index , partly reflecting the possibility of a rights issue.

Media reports have estimated Russell's indices earnings at $200 million. A similar multiple to that of MSCI would give that business a value of around $2.4 billion, while the asset management arm is estimated to be worth $1 billion, from pretax earnings of around $100 million.

LSE had pretax profits of 289.9 million pounds ($489.1 million) last year.

($1 = 0.5927 British Pounds) (Editing by Jason Neely and Mark Potter)