Market-Cap Together With Growth-Value Arbitrage

Predicting whether small-cap or increment stocks volition outperform large-cap or value stocks inwards the side yesteryear side quarter is a favorite pastime of fiscal commentators. To many fiscal economists, however, the interrogation is long agone settled yesteryear the so-called Fama-French Three-Factor Model. This model postulates that the returns of a stock depend mainly on three factors: the full general marketplace position index returns, the market-cap of the stock, as well as the book-to-price ratio. Furthermore, every bit an empirical fact, over the long term (i.e. for whatever 20-year period), small-caps shell large-caps yesteryear an average compounded annual charge per unit of measurement of 3.12%, as well as value stocks shell increment stocks yesteryear 4.06% (the latter effect applies when nosotros restrain ourselves to the large-cap universe).

This model is really convenient to us arbitrageurs. Statistical arbitraguers to a greater extent than ofttimes than non don’t know how to predict marketplace position index returns, simply nosotros tin soundless brand a living inwards a ship marketplace position yesteryear buying a small-cap, value portfolio as well as shorting a large-cap, increment portfolio, as well as human face to earn 3-4% (on one-side of capital) a year. For example, despite the much anticipated imminent demise of small-caps over the final twelvemonth or so, I establish that if nosotros long the small-cap value ETF IJS, as well as brusk the large-cap increment ETF IVW from Nov 15, 2005 to Nov 15, 2006, nosotros would induce got earned nearly 10% return. The 3-4% average returns human face meager, simply greenback that since this is a market-neutral, self-funding portfolio, your prime number broker (if y'all merchandise for a hedge fund or a proprietary trading firm) volition let y'all to leverage this furnish several times.

Some traders volition honor twenty years a fighting likewise long. Is at that topographic point whatever aid from academic theory on whether small-cap value volition outperform large-cap increment side yesteryear side month, as well as non side yesteryear side twenty years? Influenza A virus subtype H5N1 latterly published column explaining this inwards the New York Times recently.) The substance of this article is that when marketplace position persuasion is positive, human face small-caps to underperform large-caps yesteryear 0.26% a month, as well as value stocks to outperform increment stocks yesteryear 1.24% a month. Conversely, when the marketplace position persuasion is negative, human face small-caps to outperform large-caps yesteryear 1.45% a month, as well as value stocks to underperform increment stocks yesteryear 1.04% a month. How 1 computes “sentiment” is complicated: it is a linear combination of half dozen variables: closed-end fund discount, NYSE portion turnover, number as well as first-day returns on IPOs, equity portion inwards novel issues, as well as the dividend premium. (The authors used information from 1963-2001 for this study.) Now, without genuinely computing all these variables, most would grip that the electrical flow persuasion (as of Dec 2006) is fairly positive. This implies, every bit Mr. Hulbert noted, that small-cap volition underperform large cap inwards the coming months, opposite to the long-term trend. However, the other long-term trend, that value volition shell growth, volition soundless grip inwards the close future. It is upward to the reader to honor a distich of ETF’s that volition accept maximum payoff of this prediction, simply I volition aid hither yesteryear tabulating unopen to of the available funds.

	Value	Blend	Growth
Large cap	IVE	IVV/SPY	IVW
Mid cap	IJJ	IJH	IJK/JKH
Small cap	IJS	IJR	IJT

Further reading:

Bernstein, William (2002), The Cross-Section of Expected Stock Returns: Influenza A virus subtype H5N1 Tenth Anniversary Reflection.
O’Shaughnessy, James P. (2006), Predicting the Markets of Tomorrow. Penguin Books.