Friday, December 22, 2006

iShares IWC and IWB ETFs: Tracking the Smallest and Largest Caps

Small capitalization stocks, such as those included in the Russell 2000 Index, have received increasing attention from investors. The iShares IWM ETF, which tracks the Russell 2000 Index, has gone from an average daily volume of a little over 12.6 million shares in 2004 to almost 46.9 million shares during 2006.

Interestingly, however, the corresponding smallest of the small cap funds, the iShares IWC ETF, which tracks the Russell Microcap Index, has averaged only about 76,500 shares per day since its inception in August of 2005. This index captures the smallest 1000 of the Russell 2000 stocks, plus the next smallest 1000 companies. As noted in an earlier article, IWC is a passive index that represents the price behavior of these smallest cap stocks, unlike the PZI ETF, which actively rebalances its microcap holdings. This makes IWC a superior vehicle for studying the market performance of microcaps.

So how does the price behavior of the microcaps differ from that of the largest cap stocks. For the chart above, I chose the corresponding iShares Russell 1000 Index ETF, IWB, for comparison. That index, as its name implies, captures the performance of the 1000 largest companies by market capitalization. This provides a nice basis for comparison since there is no overlap between the stocks in the IWB and IWC products.

Notice that the microcaps (red) have swung more dramatically than the large caps (blue). Indeed, the average daily range of the IWC ETF since its August, 2005 inception has been about 1.2%, considerably larger than the .87% average daily range of IWB over that same period.

The two ETFs tracked one another pretty closely during most of 2005. During early 2006, however, we saw the microcaps dramatically outperform the large caps up to the May high. At that point, with the unwinding of the carry trade and weakness in emerging markets, the microcaps dropped precipitously. Since the July lows, the two ETFs have again tracked each other relatively closely. As a result, however, the large cap IWB has been making multi-year highs, whereas the microcap IWC has yet to exceed its May peak. In fact, though their paths have been different, the net performance of the large caps and microcaps since August, 2005 has been equivalent.

In line with my earlier article on the EEM emerging markets ETF, we might view the relative performance of IWC and IWB as a kind of sentiment measure. When the microcaps are outperforming the large caps, there is positive speculative sentiment in the market, as we saw during the runup to May. Conversely, when investors are bailing out of the microcaps relative to large caps, as occurred this past summer, relative defensive sentiment prevails.

When IWC and IWB are down concurrently, we have a pretty good indication that traders are fleeing equities. Conversely, when we see a concurrent rise in IWC and IWB, we know that traders are more favorably inclined toward stocks. Since the introduction of IWC in August, 2005 (N = 332 trading days), that has been a contrary indicator for the microcaps.

Specifically, when both IWC and IWB have been up over a five-day period (N = 153), the next five days in IWC have averaged a loss of -.31% (67 up, 86 down). When both IWC and IWB have been down over a five-day period (N = 109), the next five days in IWC have averaged a gain of .72% (70 up, 39 down). That's quite a discrepancy, suggesting that the best time to buy the microcaps has been when traders have not been loving stocks.