For many, the volatile decline in the markets which started in the last week of July and bottomed on August 16th was an unusual correction. During that period, it was difficult for investors to predict from one day to the next whether the market would rebound or take a nose dive lower. Mainstream media had a major story about the credit rout and spoke of recessionary fears resulting from the sub-prime fallout nearly every day. Panic clearly prevailed.
It was a scary time for most active managers. Several news stories during and after the decline described the large draw-downs experienced by quite a few hedge funds. Prominent among these were various "quant funds," which use mathematical models to choose positions and build portfolios. Many active managers, it appears, performed poorly in August, despite the solid close for the broad market.
The question I'd like to pose is whether what we saw in the first 2 weeks of August was a "traditional" correction, and perhaps try to understand what happened beneath the surface of the broad market indices. I use the term "traditional" because historically corrections result in Small-Cap indices underperforming their Larger-Cap brethren, causing some of the most painful losses for such companies during the decline. This makes intuitive sense because Small-Cap companies are generally more volatile and have higher betas than Large-Cap companies. So how did Small-Cap ETFs perform from the beginning of August to the bottom of the decline on August 16th?
As you can see in the data above, the S&P 600 Small Cap ETF (IJR) and the Russell 2000 ETF (IWM) actually outperformed the Large-Cap S&P 500 ETF (SPY) and the Russell 1000 ETF (IWB) during the decline, suffering only minor losses! This seems quite counter-intuitive, even from an economic and fundamental standpoint. After all, a squeeze on the credit market should affect smaller companies who need that funding the most. On the other hand, larger companies might be somewhat less affected because of their generally healthy balance sheets and cash reserves. What does market-cap performance imply about the decline and the way investors behaved? What truly caused the market decline to begin with?