Bloomberg News

Russell VIX at Two-Year High as Small-Cap Hedges Climb: Options

October 11, 2011

Oct. 11 (Bloomberg) -- The cost of options to protect against losses in smaller U.S. companies has risen to a two-year high against Standard & Poor’s 500 Index contracts on concern they will fare worse should the economic slowdown intensify.

The Chicago Board Options Exchange Russell 2000 Volatility Index is priced 12.60 points higher than the CBOE Volatility Index, or VIX, which tracks contracts on the S&P 500. That’s the most since the record 12.84 points set in April 2009, according to data compiled by Bloomberg. The gap has widened from this year’s low of 2.93 on July 13.

Analysts cut profit projections for Russell 2000 companies this year on concern they are more vulnerable to slowing U.S. growth because they derive less revenue from outside the country, said Barry Ritholtz, who oversees about $300 million as chief executive officer of New York-based FusionIQ. Russell 2000 Index stocks, with a median market capitalization of $431 million, have lost 19 percent since July 22, compared with an 11 percent loss in the S&P 500, where the value is $10.5 billion.

“Small caps have the least ability to absorb the punches,” Ritholtz said during a telephone interview on Oct. 7. “They tend not to be global, they tend to be more concentrated in a sector or industry, and are more dependent on a single product.”

‘Everything Necessary’

The options index for the Russell 2000 fell 5.6 percent to 45.62 yesterday, while the S&P 500 derivatives gauge dropped 8.8 percent to 33.02, after German Chancellor Angela Merkel said European leaders will do “everything necessary” to ensure that banks have adequate capital. On average during the past eight years, the Russell index has been 6.54 points higher than the S&P 500 gauge, data compiled by Bloomberg show.

The Russell 2000 VIX fell 2.7 percent to 44.37 today, while the VIX declined 0.5 percent to 32.86.

The Russell 2000 has surged 12 percent and the S&P 500 has risen 8.7 percent since Oct. 3, the biggest rallies over the same amount of time since 2009, on optimism European leaders will take action to end the crisis. The small-cap index has done worse in 2011 than the large-company measure, dropping 13 percent versus a 5 percent drop.

Analysts have raised 2011 earnings estimates for the S&P 500 by 4.8 percent since the start of the year and reduced them by 10 percent for the Russell 2000, according to average projections compiled by Bloomberg. For 2012, they increased forecasts by 3.6 percent for the large-stock measure and cut them by 2.6 percent for the small-company gauge, the data show.

“Small-cap stocks tend to be viewed by asset allocators as a higher-risk asset class,” Chip Miller, the U.S. small-cap equity strategist at UBS AG in Stamford, Connecticut, said in a telephone interview yesterday. “Their earnings are more volatile, and they tend to be more economically sensitive.”

More Growth

Even after analysts cut projections, they see Russell 2000 companies posting 38 percent and 40 percent earnings growth in 2011 and 2012, according to the average estimates. That’s double and triple the projected rates for the S&P 500, the data show. For China’s Shanghai Composite Index, the forecast for next year’s growth is 19 percent.

“People hear ‘small’ and immediately think high-risk, which is a very naive way to look at the market,” Dan Veru, who oversees $3.4 billion as chief investment officer at Fort Lee, New Jersey-based Palisade Capital Management LLC, said in a telephone interview yesterday. “We’re very bullish on small caps. These stocks have some of the same growth attributes as emerging-market stocks with a heck of a lot less risk.”

Small caps are less able to endure a global slowdown than S&P 500 stocks, according to Scott Tapley, who helps oversee $2.5 billion at 1st Source Investment Advisors Inc. in South Bend, Indiana.

North American Focus

The median company in the Russell 2000 takes in all of its revenue from North America, compared with 74 percent in the S&P 500, financial reports compiled by Bloomberg show. Cash at Russell 2000 companies represents 32 percent of total debt, compared with 37 percent for the S&P 500, giving smaller stocks less of a cushion should the economy contract, according to data compiled by Bloomberg.

“Small caps have more to lose because their balance sheets are weaker relative to large caps,” Tapley said in a phone interview yesterday. “I’ve been adding to larger, dividend- paying, bulletproof multinationals. They’re not going away.”

--With assistance from Kaitlyn Kiernan in New York and Cecile Vannucci in Amsterdam. Editors: Nick Baker, Joanna Ossinger

To contact the reporters on this story: Jeff Kearns in New York at jkearns3@bloomberg.net; Whitney Kisling in New York at wkisling@bloomberg.net

To contact the editor responsible for this story: Nick Baker at nbaker7@bloomberg.net


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