Classic Small-Cap Trades Worked Again in 2022 (NYSEARCA:VIOO)

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In February 2013, Seeking Alpha contributor Plutos wrote: Awesome article on how to make money with small caps. He pointed out that there are two major small cap indices, the S&P SmallCap and the Russell 2000.

He continues: “The rebalancing of the Russell indices every June leads to market volatility. Because Russell index changes are rules-based and predictable, there are a large number of index changes annually (historically roughly a quarter), and the Russell 2000 index is so high that arbitrageurs can bid up prices. Future members who increase prior to indexing future sponsorship and sell/short exit components are now forced to sell these index-indexed positions. “Index Changes and Unexpected Losses for Investors in S&P 500 and Russell 2000 Index Funds” was written in 2005 by Honghui Chen of the University of Central Florida, Gregory Noronha of Arizona State University-Western, and Vijay Singhal of Virginia Tech. It estimates performance drag related to this restructuring to be between 1.30% and 1.84% annually. By comparison, the paper estimates that index changes in the S&P 500 have resulted in a loss of 0.03% to 0.12%. As the return differential between these two small-cap indices has historically been 177bp, this performance drag can account for the entire return difference.

In other words: Because it’s so easy to pre-empt changes in the Russell 2000 index, it consistently underperforms the S&P SmallCap 600.

Investors use this information to make money in two ways. Asset allocators using index ETFs use S&P SmallCap ETFs rather than Russell 2000 ETFs. Those looking for a market-neutral way to make money consider trading a pair: long IJR, short IWM.

Best performance is not guaranteed. Russell 2000 ETFs sometimes outperform the S&P SmallCap 600. The Russell 2000 consists of small-cap and low-quality stocks. So when those highly speculative asset classes perform well, the Russell 2000 outperforms the S&P SmallCap 600. At least for a while.

Will S&P SmallCap 600 ETFs Outperform Russell 2000 ETFs Again in 2023? Probably. With higher inflation and interest rates, there is little reason to expect the more speculative Russell 2000 stocks to outperform the higher quality S&P SmallCap 600 stocks. And Russell 2000 ETFs will once again be weakened by the downward index dynamics observed by Plutos.


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