Managing international portfolios with small capitalization stocks

In the context of an international portfolio diversification problem, we find that small capitalization equity portfolios become riskier in bear markets, i.e. display negative co-skewness with other stock indices and high co-kurtosis. Because of this feature, 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. The dominant factor in inducing such shifts in optimal weights is represented by the co-skewness, the predictable, time-varying covariance between returns and volatilities. We calculate that if an investor were to ignore co-skewness and co-kurtosis risk, he would suffer a certainty-equivalent reduction in utility equal to 300 basis points per year under the steady-state distribution for returns. Our results are qualitatively robust when both European and North American small caps are introduced in the analysis. Therefore this paper offers robust evidence that predictable covariances between means and variances of stock returns may have a first order effect on portfolio composition.