Hedge Funds Pare Russell 2000 Shorts as Cost of Protection Drops

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Hedge-fund managers, a group of investors who lost faith in small-cap stocks last year just before they plunged, are now shedding their bearish bets prior to first-quarter earnings.

Large speculators pared their short positions in futures tied to the Russell 2000 Index to around the lowest level since April relative to long ones, according to data from the Commodity Futures Trading Commission. The measure of smaller companies, whose constituents have an average market value of $1.1 billion, trades 0.8 percent below a record reached March 20.

Speculation smaller companies’ earnings will weather a jump in the U.S. dollar better than larger counterparts are coaxing these managers to cover shorts, according to Peter Rup at Artemis Wealth Advisors LLC. In 2014, the same investors became the most bearish in two years on small caps, CFTC data show, before the Russell 2000 dropped 13 percent.

“What you’re seeing is perhaps a downward revision to the earnings for larger-cap companies versus small to mid-cap ones,” said Rup, the chief investment officer at New York-based Artemis Wealth, which invests in hedge funds. “It only makes sense that one would rotate out of defensive stocks into growth in the small- and mid-cap area.”

The Standard & Poor’s 500 Index added 0.7 percent to 2,080.62 at 4 p.m. in New York, while the Russell 2000 rose 0.4 percent.

Hedges Fall

Shares of smaller companies have outperformed the S&P 500 in 2015. The Russell index has jumped 4.2 percent this year to 1,255.66, while the S&P 500 has risen 0.4 percent to 2,066.96. The broader-market measure trades at 1.65 times the Russell 2000, the lowest ratio since July.

Options traders are siding with hedge-fund managers by reducing their hedges on an exchange-traded fund tracking the Russell 2000. The cost of options on the iShares Russell 2000 ETF dropped to 1.17 times that of the SPDR S&P 500 ETF Trust last week, around the lowest ratio since 2008, one-month data compiled by Bloomberg show.

S&P 500 earnings growth is poised to pause as the dollar trades near a 10-year high and oil prices hover around a five-year low. Companies in the U.S. benchmark gauge face three quarters of declining profits, the longest stretch since the 2008-2009 financial crisis, according to analyst estimates compiled by Bloomberg.

Falling profit expectations for larger companies have diverted investors’ attention to the smaller ones, which reap more of their business from North America, says Randy Frederick at Charles Schwab Corp.

“As we go into earnings season, the most impacted will be those in the energy sector and those with international exposure, which would be bigger companies,” said Frederick, managing director of trading and derivatives at Charles Schwab. “Smaller companies tend to be underexposed to international sales.”

Diverting Attention

Analysts expect profit for Russell 2000 companies to expand 83 percent in the next 12 months, while S&P 500 corporations’ earnings are predicted to rise 8.1 percent in the same period, Bloomberg data show.

Russell 2000 companies get an average of 83 percent of their sales from North America, according to data from the firms in the index that provide the information in their financial statements. That compares with 70 percent for S&P 500 companies.

As large speculators close out their Russell 2000 shorts, traders in the iShares ETF have added to theirs. Short interest on the fund is up 65 percent from a low in February to 30.6 million shares, Markit Ltd. data show, as the small-cap index has jumped 7.5 percent in the past two months.

Priced In

Depressed earnings expectations for large-cap stocks may even provide a boost to their shares price. Earnings forecasts have been cut so much that there’s a high probability corporations will beat them, according to Todd Salamone at Schaeffer’s Investment Research Inc.

“A lot of people are expecting the worst due to this dollar strength,” said Salamone, senior vice president at Cincinnati-based Schaeffer’s. “This stronger dollar could be a positive for equities now that we’ve created a much lower bar for the earnings season.”

Analysts have lowered their expectations for S&P 500 companies’ first-quarter earnings 13 percent since the beginning of October, according to surveys conducted by Bloomberg.

The Russell 2000 trades at 47.3 times profit, below its average price-earnings ratio of 49.6 times last year. Valuations on the index climbed as high as 60.7 times in 2014, in the midst of a 13 percent plunge from March to October.

The Chicago Board Options Exchange Volatility Index, a gauge of options costs on the S&P 500, slid 2.7 percent to 14.67 last week. The CBOE Russell 2000 Volatility Index, a similar measure for small-cap stocks, dropped 4.4 percent to 17.2.

“All of a sudden there has been this urge to own small caps,” JC O’Hara, the New York-based chief market technician at FBN Securities Inc., said by phone. Traders “were watching them and waiting for a spark. The dollar strengthening ahead of a potential rate hike was that spark.”

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