What We’ve Seen
In response to last week’s announcement that the U.S. will increase tariffs from 10% to 25% on $200 billion of goods, China announced countermeasures to impose tariffs on $60 billion of U.S. goods on June 1. In a signal of further retaliation, the U.S. has floated the idea for 25% tariffs on an additional $300 billion of Chinese imports. This secondary basket reaches deeper in the pockets of the U.S. consumer as it includes many consumer goods, which have so far not been as impacted.
During the previous week, investors had greater faith that the most recent round of trade talks would end in a favorable way, or that President Trump would simply back down in the name of deal-making, which would have been more consistent with the rhetoric that talks were progressing well. This prior trade rhetoric was undoubtedly helping markets close well north of their lows on Wednesday, Thursday and Friday.
Of course, that came crashing to a halt on Friday night (May 10) when the tariffs went through. With the reality of a breakdown in trade talks between China and U.S. and what a bear-case scenario could bring to the U.S. consumer and corporate profits, implied volatility for Large Caps and Small Caps spiked to 20.55 and 23.74, respectively, on May 13, which was the highest level for both since January 8. It was the worst single day for Large Caps since January 3 and March 22 for Small Caps. This level of implied volatility is 31% higher for Large Caps and 25% higher for Small Caps on the year, and 45% and 32% higher, respectively, over the last 3 years. This may be more of a sign of the low volatility regime that permeated markets, but also highlights the reality that geopolitical risks remain a market driver alongside the path of monetary policy and the related feedback loop between the two.
Implied Volatility Jumped on Monday
Source: Bloomberg Finance, L.P., as of May 14, 2019. Large Cap defined as the S&P 500 Volatility Index and Small Cap defined as the Russell 2000 Volatility Index. One cannot invest directly in an index.
Money in Motion
As of yesterday’s close, Large Caps have seen $11.73 billion of outflows, while Small Caps have seen $1.09 billion of outflows, over the last month. Interestingly, if one excludes the largest Large Cap and Small Cap ETFs, which are primarily favored by tactical traders as opposed to asset allocators, both categories would be positive, potentially pointing the broader investment community remaining unfazed by the recent bout of volatility.
Thanks to a streak of daily outflows for Large Caps, relative 1-month flows between Large Cap and Small Cap ETFs shifted in favor of Small Caps on May 9. Prior to that, ETF investors had favored Large Caps every day since March 11 with a peak difference of $23.08 billion in favor of Large Caps on April 9. Taking a longer-term view, Large Caps have dominated relative flows over the last 3 years taking in 3.7 times the flows into Small Caps with $141.56 billion in inflows compared to $38.56 billion in inflows for Small Caps. Over the last year, there are signs that this pace is slowing; Large Caps have seen $18.37 billion in inflows, and Small Caps have seen $8.05 billion.
Source: Bloomberg Finance, L.P., as of May 14, 2019. Data represents the relative net flows of U.S.-listed U.S. Large Cap ETFs and U.S. Small Cap ETFs specifically targeting exposure to U.S. Large Cap and U.S. Small Cap stocks, respectively. For example, when the blue bars and orange line are positive, U.S. Large Cap stocks gathered greater flows than U.S. Small Cap stocks. On the other hand, when the blue bars and orange line are negative, U.S. Large Cap stocks gathered less flows than U.S. Small Cap stocks.
In order to gauge how this most recent episode of volatility may impact future returns, we identified 4 periods over the last 3 years that saw significant spikes in volatility. Using the date of the peak level of the VIX in June 2016, October 2016, February 2018 and December 2018, this study highlights how buying the dip has paid off for investors over the last 3 years. In fact, it has paid to buy Small Caps over Large Caps. In the 3 months following these spikes, Small Caps outperformed by 4.16%. Throughout the 6 months following a volatility spike, Small Caps outperformed by 5.12%. While returns heading into these events were mixed with some positive and others negative, Small Caps outperformed in all 4 of the subsequent periods.
Looking ahead, outside of the economic impacts, additional tariffs would likely further dampen investor sentiment causing the risk of buying the dip to not work as well as it has over recent history. The impact that further tariffs would have on increasing inflation further complicates the idea that the US Federal Reserve would cut rates as opposed to needing to increase them. Of course, much of this is speculative as there remains time for a deal to be completed that would limit the negative impacts and make buying the dip a continued winning move. Investors should watch how the market balances the quality that Large Caps tend to provide relative to the lower exposure that Small Caps may have to international trade.
Small Caps have Outperformed Large Caps following Recent Volatility Spikes
|Large Cap||Small Cap|
Source: Bloomberg Finance, L.P., FTSE Russell, as of as of May 14, 2019. The data represents an average of the performances prior to and following volatility spikes in June (2016), October (2016), February (2018), and December (2018).
- For those believing that the recent volatility increase will be consistent with investors’ experience over the last 3 years, the Direxion Russell Small Over Large Cap ETF [RWSL] offers 150% exposure to the Russell 2000 Index and -50% exposure to the Russell 1000 Index allowing them to amplify a positive view on Small Cap companies and benefit directly benefit from their potential outperformance over Large Caps.
- Another group of investors may have the opposite opinion and believe that buying the dip may no longer be reliable thanks to the increased uncertainty on the macro direction, the Direxion Russell Large Over Small ETF [RWLS] allows investors to gain exposure to Large Caps relative to Small Caps.
- Russell 1000® Index: The Russell 1000 Index consists of the largest 1,000 companies in the Russell 3000 Index, which is made up of 3,000 of the largest U.S. companies.
- Russell 2000® Index: The Russell 2000 Index is comprised of the smallest 2,000 companies in the Russell 3000 Index, representing approximately 8% of the Russell 3000 total market capitalization.
- VIX® Index: The Cboe Volatility Index® reflects a market estimate of future volatility, based on the weighted average of the implied volatilities for a wide range of strikes.
Relative Weight ETF Risks: Investing involves risk including possible loss of principal. The Funds’ investments in derivatives may pose risks in addition to, and greater than, those associated with directly investing in or shorting securities or other investments. Investing in, and/or having exposure to, small and/or mid-capitalization securities involves greater risks and the possibility of greater price volatility than investing in larger, more-established companies. There is no guarantee that the returns on the Funds’ long or short positions will produce high, or even positive returns and a Fund could lose money if either or both of the Fund’s long and short positions produce negative returns. Please see the summary and full prospectuses for a more complete description of these and other risks of the Funds.
Distributor: Foreside Fund Services, LLC