A Large-cap/Small-cap Arbitrage Approach

The simultaneous withdrawal of liquidity from the system by central banks of the world will no doubt have a significant impact on the market. A slowing economy and higher interest rates have already contributed to the recent pullback in stocks. With talks of inverted yield curves, asset bubbles, increased volatility, and recession, the arduous task of investing is becoming increasingly more dangerous. There are opportunities, but systematic risk is still present.

One way to hedge away the systematic risk is to bet on a shift in investor preference for stocks of specific market capitalizations. The scenario described above would be expected to favor quality large cap stocks over their less capitalized and generally more speculative small and micro cap brethrens. Large cap companies generally have greater access to cash, stronger credit ratings, lower sensitivity to cyclical swings, larger operations diversified across foreign economies, and broader currency exposure that creates a natural hedge against the dollar.

An investor could engage in arbitrage using ETFs. Buying the iShares Russell 1000 Index ETF (IWB), would create the long exposure to large caps. Simultaneously shorting an equal amount in the Russell 2000 Growth (IWO) or Russell Microcap Index (IWC) would theoretically take away the systematic risk and yield the small-to-large capitalization bet (not accounting for differences in liquidity of the ETFs).

Small caps have been outperforming large caps in recent years, but if you believe the trend may be reversing then this setup would be a good way to play it.

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