Last summer, I often covered the difference in short-term performance between the Russell 2000 and S&P 500.  I suggested that the VIX, as a measure of implied volatility, was a good predictor for this capitalization premium, and that claim often held up.  I even went so far as to analyze the high-amplitude periods of this relationship.  However, as the actual volatility of volatility has increased dramatically since last fall, my suggestions have been more and more difficult to implement. 

I wanted to explore why this relationship had changed, and so I've taken a look at the Dow 30 (DIA), S&P 500 (SPY), and Russell 2000 (IWM) since 2002.  The figure below shows the cumulative return of each index ETF in the top pane.  The bottom pane shows  the trailing 100-session percentage-correlation between each pair of indexes.

One of the most striking features of these plots is that all three indexes are trading at or above their highest historical correlations on this range.  The only timespan of comparable length was during late 2002 and early 2003 as a short bear market held sway. 

The other relationship that caught my eye was that the trend in correlation between the indexes was inversely related to the overall market performance.  In other words, as the correlation between indexes fell, the markets rose on average.  Furthermore, during these falling correlation periods, the Russell often outperformed its counterparts, and vice versa in rising correlation periods.  This relationship likely reflects the fact that the capitalization premium and discount on small caps and large caps is very much a function of the strength of the economy and credit market. 

In the future, I'll be watching closely for a decline in the correlation between these indexes as a confirmation of overall market uptrend.

ProShares has offered a variety of "Ultra" and "UltraShort" sector ETFs for more than a year now.  These funds are designed to track twice the return of the underlying index, and each corresponding long fund is created to match its corresponding short. 

There is no doubt that these ProShares offerings have been the subject of a great deal of interest.  They promise the rewards of leveraged sector returns without the headache of margin or portfolio construction, allowing profitable bets with less capital and less risk.  This might not come for free, however, and many have investigated how closely these funds track their double-return target in terms of price.  For more on that topic, I suggest this article directly from ProShares.

Instead of asking whether these funds track twice their underlying index, however, I've decided to investigate whether each pair of funds behaves as expected.  That is, given two well-constructed  index portfolios, the sum of the long fund's return and the short fund's return should equal zero.  Though the behavior of the underlying derivatives might be expected to introduce some tracking error, we should  expect to see only relatively small differences relating to the difference between price and NAV.

The following chart demonstrates the cumulative return difference between the long and short funds.

The chart demonstrates that this is far from the case.  In fact, nearly half of the sectors have seen over 20% deficits in this balance since June of last year.

Looking for explanations outside of portfolio construction leads to a believable alternative.  Charting dollar volume differences shows that almost every single sector had greater dollar volumes on the short side.  In some sectors like Materials and Real Estate, the difference in dollar flow over the past year has hit tens of billions.  It seems likely that these funds are much more valuable as insurance for the down-side than as single-sector long bets.  In other words, if investor are much more likely to bid on and bid up an UltraShort Sector insurance contract, imbalances such as these might be expected.

  The past week provided the first signs of support in the overall market for a long while, with financials rising, energy falling, and two consecutive overall days in the black.  The top gainers relative to the S&P for the week were financials and materials, with energy and technology falling the hardest compared to the market.  Crude fell below $90 on Friday as well, likely decreasing inflationary pressure and giving the Fed less downside risk for lowering rates, further widening the difference between financials and energy.

  With respect to volatility, utilities and staples remained the least risky relative to the S&P, with financials and discretionary coming up on top on the other side.

  Here are the table summaries.

 Return

Volatility

I've covered sector minimum spanning trees many times in the past, and here we see the current trees for the past week and month.  As minimum paths within the log-return correlation matrix, they represent the structure and dynamics of the market as broken into sectors. 

Notice that utilities and energy have been especially distant from the S&P and that the Russell has been most tied to the weak discretionary and financials over both intervals.

Week MST

Month MST

In the past, I've covered the difference between long-term and short-term sector-to-market correlations as a possible arbitrage opportunity.  I've performed the analysis just as before, comparing the correlation over the past 50 periods to the previous 500 periods. 

  Note that relative to September, most sectors are much closer to the fair line (50-session correlation = 500-session correlation).  Most noticeably changed is energy, which is currently exhibiting a much higher correlation.  Note as well that financials and consumer discretionary seem much less attractive in a possible bear market, while utilities comes is actually even less correlated currently than in the long-run.

Here is the table of the actual differences.

    The divergence between sectors over the last few weeks has marked, with financials and consumer discretionary getting hit the worst.  On the upside, concerned investors have reward the consumer staples and utilities funds, both for their safer profile and attractive dividends with falling rates.

    Here are two tables summarizing the performance of the Select SPDR Sector ETFs relative to the S&P 500.  The first table shows the excess log-return over the indicated period between the fund and the S&P 500 tracker, while the second table shows the amount of volatility (standard deviation of log-return) above the S&P 500 over the specified interval.

Excess Returns 

Excess Volatility

Dollar-Weighted Category Summary

Top 10 ETF and CEF Advances and Declines

    Since the S&P's last low on August 27th, the trailing monthly distribution of daily Select Sector SPDR ETF returns has made new records.  The following is a chart of the 20-session average skew and kurtosis of the SPDR sector ETFs and the SPY.  It is very important to note, however, that I have calculated these numbers within each day - that is, these are the moments of the distribution of returns for each day, not the distribution of returns for each fund.  Thus, for 20 days, there are 20 values for each moment, and the graph represents the average of these 20 values.  These numbers are therefore an indicator of how symmetric and tight the sector returns have been over the past month.  Lower kurtosis implies sectors moving within a tighter range, and thus likely higher sector correlation.  Skewness indicates which tail is fatter, and thus the symmetry of the overall sector returns.

    See how the kurtosis has reached an all-time low for these funds, dropping past the lows of July 2004.  Skewness as well seems to be surfing along zero, implying a relatively symmetric and tightly central distribution of returns since the Fed cut.