Stocks can be classified into many types: value vs. growth, profitability vs. investment, developed vs. developing countries, and, of course, large vs. small caps. Today, we present a large cap vs small cap rotation trading strategy.
The large-cap vs. small-cap rotation strategy aims to shift between these two groups to capitalize on the one that is performing the best, essentially, the one with the most momentum. But is this strategy profitable?
In this article, we are going to discuss what the large cap vs small cap rotation strategy is, develop a trading strategy, and backtest it.
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What is the large-cap vs small cap rotation strategy?
The terms “big-cap” and “small-cap” are generally self-explanatory, referring to companies’ market capitalization sizes. Big-cap stocks represent shares of larger, more established companies, while small-cap stocks are associated with smaller, typically faster-growing companies.
S&P 100 and S&P 500 are examples of large caps, while Russell 200o is often referred to as small cap.
Small-cap stocks hold appeal due to their comparatively lower valuations and the potential for them to mature into large-cap stocks over time. This is partially the reason why they have historically performed better than large caps. However, this is not the case 100% of the time, as there are periods when large caps outperform small caps. The outperformance is referred to as the small cap effect (factor).
The large-cap vs. small-cap rotation strategy aims to take advantage of the group that is performing better at the time. By shifting between these groups, the strategy aims to harness momentum and achieve superior returns. To test this, we are going to develop a trading strategy and backtest it.
Large cap vs small cap rotation strategy – trading rules
For the rotation system we are going to use the IJR (iShares Core S&P Small-Caps) and SPY (S&P 500) ETFs.
First, we are going to calculate the ratio between these two ETFs by simply dividing IJR and SPY. Then we put the ratio into a trading indicator and we make one trading rule to buy and one for sell.
Further down you’ll see that the strategy is pretty good and outperforms buy and hold for both. Thus, we only reveal its trading rules for our paying members. The trading rules are available for Silver Members – you join here. In addition to this trading strategy you hundreds of other ideas and relevant code. For a full list of code and logic press here.
The strategy could be classified as a momentum trading strategy.
Large cap vs small cap rotation strategy – backtest
We started the backtest in 2000, right at the peak of the tech bubble. The data is adjusted for dividends and splits. Here is the equity curve:
The returns are quite satisfactory.
Here are some performance metrics and statistics of the strategy:
- CAGR is 10.61% (small 9.60%, large 7.19%)
- The standard deviation is 21.70 (23.31, 19.53)
- Maximum drawdown is -44.08% (-58.15%, -55.19%)
The strategy performed better than “buy and hold” of both the small and large-cap ETFs. It is a little more volatile than the large cap but it has a lower drawdown than both ETFs. Overall, it seems like solid trading strategy, although it could still be improved.
Large cap vs small cap rotation strategy – conclusion
To sum up, today we showed you a large-cap vs. small-cap rotation strategy that takes advantage of the group that is performing the best at the time. We backtested the strategy and found that it performed better than owning both ETFs (IJR and SPY).