RUT Hedge Fund Puke?

On the off chance that there are readers out there who have not bothered to read Bernie Schaeffer’s market commentary because it requires a free registration to Schaeffer’s Research, you really should rethink that idea. Take, for instance, Schaffer’s “Monday Morning Outlook: Fear Swells Amid Market Pullback,” which was published earlier this morning. Here Schaeffer pulls a gem from Stonebrook Structured Products, a provider of hedge fund replication strategies:

“A large part of hedge fund returns are driven by shorting large-cap growth and the going long small-cap value and emerging market equity. True alpha accounts for only 20-25% of industry returns.”

Schaeffer extends this idea to come up with a hypothesis for the recent substantial performance gap for small caps (as evidenced by the Russell 2000 falling almost three times as hard as the large cap indices):

“Once the more volatile smaller-cap stocks began to seriously under perform the S&P, their short S&P hedges were not sufficiently protecting them (which caused them to be ‘too long’ in a market correction) and the hedge funds then needed to go out and sell stock from their portfolios and/or short the IWM or buy IWM puts. And all of this served to further blast the IWM.”

Interestingly, a look at the volatility of the Russell 2000 index (RVX) compared to the VIX does not reveal the underlying dynamic that Schaeffer suggested, but a study of the ratio of the IWM to the SPY does support his contention. See the two charts below for a better sense of this.

One key takeaway from this exercise is that some important volatility-related information is flying under the radar of the volatility indices. Another key takeaway is that ETFs are not only the driving the force in the markets these days, but they need to be a central part of any market technician’s analytical toolbox as well.