One of the sales pitches for alternative investments is that they do not rely on a bull market to generate gains. Many strategies, such as long-short, convertible arbitrage and market-neutral, are designed to exploit opportunities derived from the convergence of related assets.
Spread trades are staples in the worlds of futures and options. The rules for long and short positions are symmetric for futures, as they must be if the instruments are to serve their purposes of price discovery and risk management, but they are asymmetric for stocks. A spread involves taking a short position, and this is considered un-American in many quarters. After all, who ever heard of a downtick rule for buying stocks, and can anyone tell me what the circuit breakers are for shutting down the market during a big rally?
If investment gains going forward are going to be tough to realize as some people believe, it may be time for all of us to start trading like a hedge fund. This means working to achieve specific returns through specific trading opportunities and not relying on a bull's tailwind to push you forward. Can we exploit the spread between large-capitalization stocks as represented by the Russell 1000 (RIY) and small-capitalization stocks as represented by the Russell 2000 (RTY) as one of these strategies?
The Russell indices are used here instead of, say, the spread between the S&P 500 and the Nasdaq 100 because there is no overlap between the two indices. The Nasdaq 100 accounts for 13.37% of the S&P 500's weight.Over the course of time, the spread between the Russell 1000 and Russell 2000 has exhibited some long and persistent trends punctuated by some gut-wrenching short-term reversals. The reversals usually represent singular events such as the October 1987 crash or " Microsoft Monday" in 2000. The trend since early 1999, highlighted with a channel line, has been for the Russell 2000 to outperform. We have to look behind the gross numbers and into the sector detail to see why this may be happening.
|A Trending Spread
|Russell 1000 Sector Distribution
|Russell 2000 Sector Distribution
Tracking the DifferencesWhere are the biggest differences in the sector distribution of the two indices? The Russell 1000 is weighted more in diversified financial services, miscellaneous (yes, that's an actual sector name), manufacturing, oil and gas, pharmaceuticals and telecommunications. The Russell 2000 is weighted more in REITs, commercial services, Internets, electronics, gas utilities, banks and savings and loans.
|Russell 1000 vs. Russell 2000
Comparing the sector distributions of the two indices