Time to switch to small-cap? This quantitative strategy might help decide
Since the beginning of 2023, the S&P 500 $S&P 500 Index (.SPX.US)$ and Nasdaq $Nasdaq Composite Index (.IXIC.US)$ have surged, leaving the U.S. small-cap stocks lagging behind.
However, market funds began shifting towards rate-cut trades after July 11, selling tech stocks and buying small-cap stocks which are more rate-sensitive. The Nasdaq, dominated by large tech companies, has dropped over 10% since then, while the Russell 2000 $Russell 2000 Index (.RUT.US)$ , focused on small caps, once rose by 12% at the highs.
If investors had switched from large-cap to small-cap stocks in time, they could have avoided the decline in large-cap stocks and potentially benefited from the rise in small caps. So, how can investors time the rotation?
Here, we introduce a simple and actionable quantitative strategy that might help investors determine the right time to make the switch: the market cap rotation strategy.
What is the market cap rotation strategy?
This strategy quantifies the relative strength of large-cap and small-cap indices based on their performance over the past 12 days. The idea is to invest in whichever index shows greater strength.
The following chart offers a step-by-step guide.
The '12-day performance' serves as an investment signal, rooted in momentum theory, which suggests that if either large-cap or small-cap stocks start to outperform, they are likely to continue doing so for some time.
Has this strategy worked?
If investors consistently track the 12-day relative performance of the Nasdaq Composite and Russell 2000, they would have been signaled to hold the Nasdaq before July 11 and then switch to the Russell 2000 on that date. When the Russell 2000 began to dive in August, a sell signal for small-cap stocks was issued in time.
If investors had taken action according to the signals, they could have avoided the recent decline in the Nasdaq Composite and profited from the Russell 2000.
Overall, this rotation strategy has shown promising results in guiding investors through recent market conditions, particularly by not only indicating opportune buying moments but also alerting to risk amid heightened market volatility.
Limitations of the Strategy
This strategy is not perfect and may not perform well under certain conditions:
1. Suitable only for trending markets
In markets with clear trends, especially during bull markets, this rotation strategy can potentially help investors capture gains from both large-cap and small-cap stocks. However, in choppy or sideways markets, this strategy may lead to frequent trades, resulting in potential losses that might not even cover transaction fees.
2. Limited long-term effectiveness
Without considering dividend reinvestment and transaction costs, comparing three scenarios—holding the Nasdaq Composite continuously, holding the Russell 2000 continuously, and using the rotation strategy—reveals that the rotation strategy typically outperforms holding the Russell 2000 but often fails to beat holding the Nasdaq Composite over the long term.
Therefore, this strategy should be used as one of several analytical tools in specific market conditions, rather than being solely relied upon.
How to invest in small-cap indices
Indices cannot be invested in directly, but investors can replicate their performance through index ETFs.
On moomoo, you can quickly find ETFs that track major indices by navigating to Market > ETF > Index ETFs.
For example, to track the Russell 2000, besides the largest and most actively traded iShares Russell 2000 ETF $iShares Russell 2000 ETF (IWM.US)$ , there are also leveraged and inverse ETFs available, providing additional flexibility for implementing a rotation strategy.
Want to learn more about ETFs? Click here to view.
Disclaimer: Moomoo Technologies Inc. is providing this content for information and educational use only.
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