International Diversification & Small Caps
Extract from "The Penny Sleuth" thesleuth@agorafinancial.com
Borgsen and Glaser (“Diversifikationseffekte durch Small und Mid Caps?” Feb. 20,
2005): “Based on an empirical analysis of European large, small and mid cap stock indices, we find that small caps have relatively low correlations not only with large caps but also with each other. We show that small cap stock returns cannot be spanned by large cap stock returns. Furthermore, we find that diversification in Europe is likely to be more effective with a combination of small and large caps than with large caps alone.”
The authors also conclude that “large cap returns are mainly driven by global factors whereas returns on small cap stocks are primarily driven by local and idiosyncratic factors,” confirming the earlier work of Hansen and Rowenhorst and Griffin and Karolyi.
Borgsen and Glaser’s findings also corroborate earlier findings by Eun, Huang, and Lai (“International Diversification with Large- and Small-Cap Stocks,” Mar.
2004), who put it thusly: “[R]eturns on large-cap stocks are substantially driven by common global factors. In contrast, returns on small-cap stocks are primarily driven by local and idiosyncratic factors. This difference in return generating mechanism is understandable considering that many large-cap stocks tend to be those of multinational companies with a substantial foreign customer and investor base, whereas small-cap companies are likely to be more locally oriented with a limited international exposure. As a result, the gains from international diversification with large-cap stocks can be modest as their returns are substantially driven by common global factors. However, the same skepticism may not be applicable to small-cap stocks as their returns are substantially generated by local and idiosyncratic factors. Thus, small-cap stocks can potentially be an effective vehicle for international diversification.”
It seems no matter what part of the globe, no matter what the question, the empirical evidence always points in the same direction: small caps, small caps, small caps, again and again and again.
Borgsen and Glaser (“Diversifikationseffekte durch Small und Mid Caps?” Feb. 20,
2005): “Based on an empirical analysis of European large, small and mid cap stock indices, we find that small caps have relatively low correlations not only with large caps but also with each other. We show that small cap stock returns cannot be spanned by large cap stock returns. Furthermore, we find that diversification in Europe is likely to be more effective with a combination of small and large caps than with large caps alone.”
The authors also conclude that “large cap returns are mainly driven by global factors whereas returns on small cap stocks are primarily driven by local and idiosyncratic factors,” confirming the earlier work of Hansen and Rowenhorst and Griffin and Karolyi.
Borgsen and Glaser’s findings also corroborate earlier findings by Eun, Huang, and Lai (“International Diversification with Large- and Small-Cap Stocks,” Mar.
2004), who put it thusly: “[R]eturns on large-cap stocks are substantially driven by common global factors. In contrast, returns on small-cap stocks are primarily driven by local and idiosyncratic factors. This difference in return generating mechanism is understandable considering that many large-cap stocks tend to be those of multinational companies with a substantial foreign customer and investor base, whereas small-cap companies are likely to be more locally oriented with a limited international exposure. As a result, the gains from international diversification with large-cap stocks can be modest as their returns are substantially driven by common global factors. However, the same skepticism may not be applicable to small-cap stocks as their returns are substantially generated by local and idiosyncratic factors. Thus, small-cap stocks can potentially be an effective vehicle for international diversification.”
It seems no matter what part of the globe, no matter what the question, the empirical evidence always points in the same direction: small caps, small caps, small caps, again and again and again.
posted by HeraclitusO at 3:22 am
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