Research Article

Annals of Finance

, Volume 5, Issue 1, pp 15-48

First online:

Small caps in international equity portfolios: the effects of variance risk

  • Massimo GuidolinAffiliated withAccounting and Finance Group, Manchester Business School and Collegio Carlo Alberto (CeRP) Email author 
  • , Giovanna NicodanoAffiliated withFaculty of Economics, University of Turin and Collegio Carlo Alberto (CeRP)

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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.


Intertemporal portfolio choice return predictability Co-skewness and co-kurtosis International portfolio diversification

JEL Classification

G11 G15 F30 C32 G0 G1