Small-Caps Trail S&P 500 By Most in 6 Years on Hedge Fund Sales

By Lynn Thomasson and Elizabeth Stanton

Oct. 31 (Bloomberg) -- The smallest U.S. companies are trailing larger stocks by the widest margin in six years after hedge funds sold equities to pay back customers.

The Russell 2000 Index, where hedge funds own an average 13 percent of shares, lost 24 percent in October, ending a five- month streak of beating the Standard & Poor's 500 Index, data compiled by Bloomberg and Citigroup Inc. show. Hedge funds hold 10 percent of S&P 500 companies, according to Citigroup data.

Selling by money managers to meet redemptions helped push the S&P 500 down 18 percent this month, the most since the crash of 1987. Small-caps underperformed the S&P 500 on 15 of 22 days in October after investors pulled a record $43 billion from hedge funds last month, according to TrimTabs Investment Research.

``The redemptions and fallout in the hedge fund community will continue to affect small-cap stocks at the margin more than large-cap stocks,'' said Richard Weiss, who oversees $53 billion as chief investment officer at City National Bank in Beverly Hills, California.

Small-cap stocks beat bigger companies for most of the year as the U.S. subprime-mortgage market collapse took a steeper toll on bigger banks and brokerages, while surging energy and materials prices benefited smaller producers more.

The lead disappeared in October as credit markets froze and fuel and metals prices slid on the prospect of a global recession. Governments around the world injected $2 trillion to stabilize the financial system after bank borrowing rates surged. The Reuters/Jefferies CRB Index of 19 commodities dropped 23 percent this month, the most since the data started in 1956.

Advantage Erased

The small-cap plunge erased an advantage that reached 13 percentage points in September for the Russell 2000. The measure of companies with a median market value of $332.7 million is down 33 percent for the year. The S&P 500, composed of companies with a median value of $7.1 billion, dropped 35 percent.

Hedge funds, which are private, largely unregulated pools of capital that invest in stocks, bonds, commodities and currencies, exacerbated the trend, said Lori Calvasina, Citigroup's small- and mid-cap strategist in New York.

``You had the fundamental reasons of commodity prices falling and lingering concerns about a recession, but the swiftness and the severity came from hedge funds unloading massive stakes,'' Calvasina said.

Energy stocks in the Russell 2000 underperformed by the most in October, sliding 17 percentage points more than oil and gas shares in the S&P 500. Hedge funds held a 12 percent stake in small-cap energy producers, exceeding the group's 9.1 percent weighting in the Russell 2000, according to Citigroup.

Buying Energy Shares

Renaissance Technologies Corp. bought a 2 percent stake in McMoRan Exploration Co. during the second quarter. BP Capital LLC raised its ownership to 1.5 percent and D.E. Shaw & Co. increased its position of the New Orleans-based oil explorer to 0.9 percent during the period, according to regulatory filings.

McMoRan surged 110 percent in the first six months of the year as it began efforts to drill the world's deepest oil well. The stock lost 46 percent this month.

Renaissance, Highbridge Capital Management LLC and Touradji Capital Management LP each took stakes bigger than 0.3 percent in oil and natural-gas producer Exco Resources Inc. during the second quarter. The Dallas-based company, which more than doubled through the end of June, sank 48 percent in October.

Jonathan Gasthalter, a representative for East Setauket, New York-based Renaissance, and Paul Welsh, spokesman for New York- based D.E. Shaw, declined to comment. Touradji doesn't comment on individual investments, said Shawn Pattison, a spokesman for the New York-based fund. Calls to New York-based Highbridge and BP Capital, based in Dallas, were not returned.

Domino's, GenTek

Hedge funds owned more than 46 percent of Domino's Pizza Inc., the second-biggest U.S. pizza chain, and GenTek Inc., a producer of water-treatment chemicals, based on second-quarter filings compiled by New York-based Citigroup. The two companies each fell more than 41 percent this month.

``There are a lot of names that I've seen no other reason for the selling than hedge funds were the biggest holders,'' said Jonathan Vyorst, senior vice president at New York-based Paradigm Capital Management Inc., which oversees about $1.7 billion.

The average hedge fund's holdings dropped 20 percent this year, according to the HFRX Global Index, which tracks performance from about 80 of the funds. The 25 stocks in the Russell 2000 most owned by hedge funds tumbled 52 percent in 2008, Citigroup data show.

Short Positions

Hedge funds closing out short positions and buying back the borrowed stock also helped drive the relative strength in small- cap stocks earlier this year, according to Steven DeSanctis, Merrill Lynch & Co.'s small-cap stock strategist, and Chris Wallis, a fund manager at Vaughan Nelson Investment Management in Houston. So-called short interest in the iShares Russell 2000 Index Fund rose to a record in June and has since fallen nearly 60 percent.

``When they went to reduce overall risk, they had to close out or buy in their shorts,'' said Wallis, who manages $2.2 billion of small-cap stocks. ``That bid is gone,'' and stock prices are ``drifting to whatever the underlying intrinsic value is going to be,'' he said.

To contact the reporters on this story: Lynn Thomasson in New York at lthomasson@bloomberg.net; Elizabeth Stanton in New York at estanton@bloomberg.net.