Pub: 15.10.15 | By Anonymous In Finance. Tags: etf small stocks timing analysis .

Recent research has rediscovered some features related to the returns of small stocks. The authors do a nice job of tying some institutional features to the effect. However, the fundamental question becomes whether a simple trader can replicate the return profile described in the paper with easily available instruments like ETFs.

Two common indices are: the S&P 500 - which really describes large stocks in the market, and the Russell 2000 - which tracks smaller stocks.

It turns out that these are two nice indices, because there is a selection of ETFs that track them. Let's take a look at the IVV for S&P 500 tracking and the IWM for Russell 2000 tracking.

The first strategy that we are going to test based on the research is that if the market return (defined as the S&P 500) in the previous month was positive, then we go long on small stocks i.e. Russell 2000, else if the market return was negative then we are not invested. The second strategy is that if the market return is positive in the previous month, then we go long small stocks, else if the market return was negative then we go long in the S&P 500.

The idea is that (according to research) small stocks react slower to information coming out in part because it takes longer to trade in them (among other reasons, read the paper).

So what do the strategy returns look like? Strategy A is going long only in Russell 2000 (IWM), Strategy B is going long either in Russell 2000 (IWM) or S&P 500 (IVV):

The return profiles are:

What did the strategy and buy and hold returns look like over time:

When did the different strategies beat the buy and hold returns:

The IWM (Russell 2000) beats IVV 71% of the time anyway. You can't do much better than that with Strategy B.

What if you had started investing in any given January of a year and held the portfolio for the subsequent years:

There are quite a few years for Strategy B (going long on IVV and IWM based on what happened in the previous month of IVV) that guaranteed that you would outperform the Russell 2000 index in every year. That has changed in 2013 and 2014. Where will the strategy go from here? Has it fallen apart? Is it because large stocks are different now or is it because small stocks are different now? Or is now the perfect opportunity to pick up the strategy again, because it will work in the future as well.