International Diversification with Small Stocks: A Two-fold Size Effect

Are there diversification and return advantages from getting off the beaten path (to small-capitalization stocks) when diversifying internationally? In their September 2006 paper entitled “International Diversification with Large- and Small-Cap Stocks”, Cheol Eun, Wei Huang and Sandy Lai compare the benefits of using large-capitalization and small-capitalization stocks to diversify across countries. Taking the perspective of a dollar-based investor, they examine diversification across ten countries with open capital markets (Australia, Canada, France, Germany, Hong Kong, Italy, Japan, the Netherlands, the United Kingdom and the United States). Using monthly size and return data for three market capitalization-based funds (large-cap, mid-cap and small-cap) for each country over the period 1980-1999, they conclude that:

• In most countries the small-cap fund has a higher mean return and higher volatility than the large-cap fund, and the mid-cap fund has a lower mean return than the large-cap fund.
• The cross-country average Sharpe ratio is 0.46 for large-cap funds, 0.38 for mid-cap funds and 0.57 for small-cap funds.
• In every country, the large-cap (small-cap) fund has the highest (lowest) correlation with the U.S.
• Small-cap funds have relatively low correlations not only with the corresponding large-cap funds but also with each other. Large-cap funds have relatively high correlations with each other, reflecting common exposure to global economic factors.
• A diversified international portfolio of large-cap and small-cap funds is about two-thirds less risky than a comparably diversified portfolio holding only large-cap funds.
• The optimal portfolio (with Sharpe ratio significantly greater than that of the U.S. market index alone) consists of: (1) the U.S. market index, and (2) international (non-U.S.) small-cap funds.
• General results hold for both in-sample and out-of-sample tests. They also hold even if trading small-cap stocks is more costly.

In summary, small-capitalization stock funds from other countries offer optimal diversification benefits for investors holding broad U.S. stock market indexes.