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Risk Goes Uncompensated as Small-Caps Trail S&P 500 Index


In the boom-and-bust world of small-cap stocks, this has been the bust part.

The Russell 2000 Index, once the bull market’s star, has seen its shine dim amid a three-month decline that has shaved almost 5 percentage points off its annual return since March 2009. The gauge, down 13 percent since early July, has fallen for six weeks, the longest slump since 2005. It’s up 68 percent since the end of 2009, versus a 71 percent gain in the S&P 500.

Not since the bursting of the dot-com bubble, when investors poured money into computer giants such as Cisco Systems Inc. and Microsoft Corp., have small-cap shares trailed their larger counterparts over a comparable stretch. Money is moving away on concern valuations are too high amid slowing global growth and declining stimulus from the Federal Reserve.

“If you’re taking more risk, you want more reward,” Richard Sichel, chief investment officer at Philadelphia Trust Co., which oversees $2 billion, said in a phone interview. “When that isn’t delivered, you want something with less volatility. The comfort level continues with more established companies with more predictable earnings and good dividends.”

The Russell 2000 lost 4.7 percent last week, amid a global selloff after the International Monetary Fund cut its forecast for worldwide economic growth and said the euro area faces the risk of a recession.

Risk Underpriced

Speculation that six years of near-zero percent interest rates would restore the U.S. economy to previous rates of expansion have sent small-caps up 250 percent in the five years since March 2009, compared with 178 percent for the S&P 500. Now small stocks are leading declines amid concern slowing growth overseas will put a brake on U.S. gross domestic product.

Federal Reserve officials said over the weekend that the threat from an international slowdown may lead to interest-rate increases being delayed. The remarks highlighted mounting concern over the improving U.S. economy’s ability to withstand foreign weakness and a strengthening dollar, and December futures on the S&P 500 slid more than 0.6 percent today.

Craig Broderick, chief risk officer at Goldman Sachs Group Inc., said Oct. 11 that markets are in danger of a shock that would expose liquidity and other risks that aren’t apparent today.

“It does feel like investors across lots of different classes, not just the shadow banks, do not actually understand that in fact these crises do periodically occur, and when they do, they’ve potentially significantly underpriced risk,” Broderick said at an event sponsored by the Institute of International Finance in Washington.

Hedge Funds

Small-cap stocks favored by professional speculators fell more than other equities last week. The 10 stocks in the Russell 2000 with the highest hedge-fund ownership fell 8.3 percent on average, according to data compiled by Bloomberg. The companies include Federal-Mogul Holdings Corp., Loral Space & Communications Inc. and Unwired Planet Inc.

Demand for protection against losses pushed the Chicago Board Options Exchange Russell 2000 Volatility Index up 22 percent last week to 24.35, the highest level since February. Eight of the 10 most-owned options on the iShares Russell 2000 ETF are puts, according to data compiled by Bloomberg.

Small-cap shares are more expensive compared to other parts of the market, making them vulnerable to bigger losses. The Russell 2000 trades at 18.3 times earnings, about two points more than an S&P gauge of the 100 biggest U.S. firms.

Valuation, Volatility

“It all comes down to the valuation and volatility,” Sam Turner, a fund manager with Richmond, Virginia-based Riverfront Investment Group LLC, said in a phone interview. His firm oversees $4.6 billion. “With valuation not in your favor, that additional volatility is going to work against you.”

By some measures in the options market, small-cap shares are poised for a rebound. The cost of bearish puts on the Russell 2000 ETF is near the cheapest in more than a year, relative to bullish calls, a sign that there’s less demand to speculate on further losses.

Options hedging against a 10 percent decline in the small-cap fund cost 5.9 points more than calls betting on a 10 percent gain Oct. 8, according to six-month implied-volatility data compiled by Bloomberg. That was the smallest spread since August 2013.

Small-cap shares have generated better returns for investors since the beginning of the bull market, though that edge is shrinking. The Russell 2000 is up 207 percent since March 9, 2009, compared with 182 percent for the S&P 500.

The IMF also said last week that the risk of equity losses in 2014 has risen and stock valuations may be “frothy.” Three months earlier, the Federal Reserve said prices were stretched for stocks in spheres such as social media and biotechnology.

“There has been fear that U.S. economic growth was not robust enough to sustain continued equity valuations at levels where they were, especially coupled with the potential for the Fed to begin raising rates next year,” Janna Sampson, who helps oversee more than $2 billion as co-chief investment officer of Lisle, Illinois-based OakBrook Investments LLC, said in a phone interview.

(Source: Bloomberg)