This Trade Designed to Avoid the Strong Dollar Is Running Into Trouble

A stock trade that looked like a layup three weeks ago -- buying U.S. small caps to dodge the impact of a rallying dollar -- is running into trouble.

Shares tracked by the Russell 2000 Index have declined in four of the last five days, dropping more than 3 percent over the stretch and exceeding losses in the Standard & Poor’s 500 Index by fourfold. Volatility is increasing with attraction to small caps dimming as the dollar retreats.

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Gradually, investors are unwinding bets on smaller companies that they had favored on grounds that their domestic focus would insulate them from the effects of a rallying currency. The Bloomberg Dollar Spot Index lost 0.5 percent on Wednesday, its sixth straight retreat.

“Buying up small caps as a bet on the domestic economy is not really working,” said Ivo Weinoehrl, who manages equities at Deutsche Asset & Wealth Management in Frankfurt. “Not only was the negative currency impact not as bad as feared for the large caps, but the dollar has also stopped rising.”

The Russell 2000, whose members get about 89 percent of revenue from the U.S., fell 1 percent on Wednesday, compared with a 0.4 percent drop in the gauge of bigger companies.

Faring Worse

Preferences for companies less likely to be hurt by dollar appreciation was building throughout 2015. An investor survey by research firm Cornerstone Macro found that 62 percent of respondents favor equities with a domestic focus, compared with 15 percent for multinationals.

Now, the threat looks overstated. In the earnings season that began three weeks ago, profits for S&P 500 companies exceeded analyst estimates by 6.8 percent, on pace to be the highest proportion in at least two years. Earnings for smaller companies beat by 5.1 percent.

Things looked better for small caps a few months ago. In the first quarter, the dollar reached its highest level in at least a decade, and the Russell 2000 overtook the S&P 500 to rally 4 percent. Exchange-traded funds focusing on small-cap stocks attracted $3.3 billion, while those tracking larger companies lost $27 billion.

Now the opposite is happening. In the last two weeks, investors withdrew $456 million from ETFs tracking smaller shares in two weeks and added $1.2 billion to those following large caps.

Hedge funds and other large speculators haven’t given up on the group. They’re the least bearish in more than a year, with a net-short position of about 4,500 futures on the Russell 2000, according to data from the Commodity Futures Trading Commission.

Wouter Sturkenboom, senior investment strategist at Russell Investments in London, says they may wish they kept the shorts on.

“Economic data have not been great, and the dollar is dropping, so everyone has just been caught a little off guard,” he said. “Small caps are really vulnerable here.”

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