Hedging with Inverse Small-Cap ETFs

Depending on whom you ask small-cap stocks have total market capitalizations roughly between $300 million and $2 billion. One segment has experienced an enormous bounce of the 2009 lows. is the Russell 2000 Index, which is made up of smaller capitalization, higher beta stocks the market cap. These stocks are some of the most speculative in nature and they’ve had a tremendous bounce from the March 2009 lows. Consider hedging this sector with inverse small-cap ETFs.

What’s the Concern for Small-Cap Stocks?

The valuations of the Russell 2000 got very expensive, especially when compared to the broader market. In December 2015, the trailing P/E for the Russell 2000 was 149 times reported earnings.1 This is terrifying, especially compared to it’s multiple of 39 in March 2000. Take a look at how high the Russell 2000 has come in relation to its two prior major peaks, 2000 and 2007. Small cap stocks could get hit disproportionately hard during the next downturn. The Russell 2000 Index is more than double the level it reached at the height of the dotcom bubble.

Another worrisome trend is the growing composition of biotech stocks in the market. Biotech stocks are some of the most volatile and speculative sectors of the stock market. In the summer of 2015, biotechs reached nearly a 7% weighting of the small-cap Russell 2000 index.2 For some perspective, this is more than twice biotech’s weighting in the broader, large-cap S&P 500 index. Small-cap biotech stocks are some of the most volatile investments in the stock market whose future, and stock price, may rely on a single FDA ruling on a single drug.

Even Janet Yellen has warned of ‘substantially stretched valuations” of some small-cap social media and biotech stocks. This speaks to the underlying risk for the Russell 2000 and its tracking ETF, IWM. It may be even more worrisome for the Russell 2000, IWO growth benchmark which has its weighting of biotech stocks at 13%. The IWO has had a stronger rebound off its March 2009 lows to its 2015 highs (4.2x) compared to the IWM’s rebound (3.8x). This disparity could also reverse on the downside with the IWO underperforming.

Finally, small-cap stocks have a liquidity problem which should get exacerbated in a sell-off. Regulations have restricted the level of trading and position sizes of market makers, post-financial crisis. When selling comes, the buyers should dry up or take much less risk when making a market. This means lower prices, quicker. The same illiquidity witnessed in high yield funds like Third Avenue could also play out in small cap funds. And just as professionals thought the illiquidity of junk bonds was overblown, the same dangerous complacency surrounds small caps. The underlying holdings of the fund were so illiquid that the fund was forced to freeze redemptions (sales) from the fund and investor’s money was essentially locked up in the fund until everything got squared away.3

Hedge with Inverse Small-Cap ETFs

Both the IWO and the IWM have LEAP (long-term options) chains going out to at least January of 2018 so there are opportunities for certain investors to hedge their small-cap stock exposure. Buying protective put options is the easiest strategy to hedge with options, although there are other strategies available that hedge with less capital outlay. But with those strategies there are a lot of moving parts and the downside exposure is usually just partially hedged. For a major stock market crash, it probably won’t hedge completely and require several steps to unwind the trade which could prove difficult in the very volatile and illiquid options markets. Speculative investors could buy the put options outright to profit from the bear market.

ProShares has an inverse small cap ETF that hedges exposure to the Russell 2000 small-cap index, the ‘Short Russell 2000’ (RWM). It aims to return the opposite of the Russell 2000 Index, and thus, the mirror opposite of IWM. The RWM has some nice attributes, including over $460 million in assets under management, solid trading volume, an expense ratio under one percent and is well diversified with arrangements with 12 different counterparties.

For more aggressive investors there is a triple leveraged inverse small cap ETF, Direxion’s ‘Daily Small Cap Bear 3X shares’ (symbol TZA). It has over half a billion dollars in assets under management and is very liquid, at least from a trading volume perspective. There is also the ProShare’s triple leveraged inverse small-cap ETF, SRTY. Keep in mind, SRTY has fewer assets under management and much less trading volume. They both have similar expense ratios of around 0.95%. Hedging small-cap exposure with these vehicles could reduce risk in your investment portfolio. Simple raising cash by selling small caps is also prudent.

Inverse small cap stock ETFs mentioned:

  • RWM
  • TWM
  • SRTY
  • TZA

 

Other ETFs mentioned:

 

1http://online.wsj.com/mdc/public/page/2_3021-peyield.html

2http://blogs.barrons.com/focusonfunds/2015/07/31/any-bubble-in-biotech-would-hit-small-caps-hardest/

3http://www.reuters.com/article/us-funds-thirdavenue-sec-idUSKBN0U022620151217

4http://finance.yahoo.com/q?s=IWO