The Investment Scientist

Why Did Small Cap Value Stocks Fall So Much?

Posted on: August 22, 2007

During this correction, the Russell 2000 Value Index tumbled 16.88% based on intra-day data. Comparatively, the peak-to-trough draw-down for the Russell 2000 Growth Index is 12.97%, for Nasdaq 100 12.38% and for S&P 500 11.91%.

This is quite usual! There are a few well-established effects in the stock market. Among them are the Small Cap Premium Effect and the Value Premium Effect. In plain English, small cap stocks outperform large cap stocks, and value stocks outperform growth stocks, in aggregate and over the long run. In the case of the Value Premium Effect, this is not due to risk. Lekonishok, Shleifer and Vishny in one of their researches, investigated how different types of stocks performed during the 25 worst months over the last 30 years. They found overall, value stocks held their value better than growth stocks. During this correction however, this pattern was broken. Why small cap value stocks fell so much, even more than small cap growth stocks? Is it an aberration? or does it portend something new academic researchers have not yet discovered?

I believe there are two reasons to small cap stocks falling more in this correction: exposure to financial sector and hedge fund liquidation.

This correction started with the news that two Bear Sterns hedge funds investing in CDOs (Collateralized Debt Obligations) and CMOs (Collateralized Mortgage Obligations) suffered severe losses and had to shutdown. That sudden event helped focus the market’s attention on that fact that subprime mortgage delinquency has jumped more than 100% in the past year. The market decided to punish all financial stocks, regardless of their subprime exposure. The value sector is over-weighted with financial stocks, mostly small community banks. For instance, 30% of the Russell 2000 Value Index made up of financial stocks. As the result, the Russell 2000 Value Index fell more than the Russell 2000 Growth Index.

The news that three BNP Paribus hedge funds also had to shutdown must have caused a run in hedge fund money that persist to this day. Overnight, Nikkei dropped more than 5% and in the previous night the South Korean Kospi dropped 7%. They do not have any subprime exposure, why punish them? Alas, hedge funds are unwinding their positions everywhere.

The run in hedge funds hit a specific type of funds called quantitative funds as well. The two Goldman hedge funds who got a $3 billion dollar bailout from Goldman Sachs belong to this type. They use long-short strategies to capture the Small Cap Premium Effect and the Value Premium Effect. The long portfolios tend be small cap and value stocks and the short portfolios tend to be large cap and growth stocks. According to a Wall Street Journal report, the two Goldman hedge funds are leveraged up to 6x. Goldman’s Global Equity Opportunities Fund had $5 billion in capital, with 6x leverage, they had $30 billion to play with. To unwind their positions, they were forced to sell their longs and buy back their shorts. With billions of dollar of selling from Goldman’s hedge funds alone, and unknown billions from other quantitative hedge funds, small cap value stocks were hit very hard.

I believe the effect of this sequence of events is transitory and small cap value investing remains fundamentally sound.

1 Response to "Why Did Small Cap Value Stocks Fall So Much?"

What Are The Different Types Of Investment…

Found your blog on yahoo – thanks for the article but i still don’t get it….

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Michael Zhuang is principal of MZ Capital, a fee-only independent advisory firm based in Washington, DC.

Twitter: @mzhuang

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