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Small Caps in International Diversified Portfolios

  • Massimo Guidolin

    ()

    (Manchester Business School and CeRP-Collegio Carlo Alberto, Turin)

  • Giovanna Nicodano

    ()

    (University of Turin and CeRP-Collegio Carlo Alberto, Turin)

We show that predictable covariances between means and variances of stock returns may have a first order effect on portfolio composition. In an international asset menu that includes both European and North American small capitalization equity indices, we find that a three-state, heteroskedastic regime switching VAR model is required to provide a good fit to weekly return data and to accurately predict the dynamics in the joint density of returns. As a result of the non-linear dynamic features revealed by the data, small cap portfolios become riskier in bear markets, i.e. display negative co-skewness with other stock indices. Because of this property, a power utility investor ought to hold a well-diversified portfolio, despite the high risk premium and Sharpe ratios offered by small capitalization stocks. On the contrary small caps command large optimal weights when the investor ignores variance risk, by incorrectly assuming joint normality of returns. These results provide the missing partial equilibrium rationale for the presence of co-skewness in the empirical asset pricing models that have been proposed to explain the cross-section of stock returns.

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Paper provided by Center for Research on Pensions and Welfare Policies, Turin (Italy) in its series CeRP Working Papers with number 68.

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Length: 50 pages
Date of creation: Nov 2007
Date of revision:
Handle: RePEc:crp:wpaper:68
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