Small Caps in International Diversified Portfolios

Massimo Guidolin and Giovanna Nicodano

No 68, CeRP Working Papers from Center for Research on Pensions and Welfare Policies, Turin (Italy)

Abstract: 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.

Keywords: intertemporal portfolio choice; return predictability; co-skewness and co-kurtosis; international portfolio diversification (search for similar items in EconPapers)
JEL-codes: C32 F30 G11 G15 (search for similar items in EconPapers)
Pages: 50 pages
Date: 2007-11
New Economics Papers: this item is included in nep-rmg
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Persistent link: https://EconPapers.repec.org/RePEc:crp:wpaper:68

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