Annals of Finance

, Volume 5, Issue 1, pp 15–48 | Cite as

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

Research Article

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.

Keywords

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

JEL Classification

G11 G15 F30 C32 G0 G1 

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Copyright information

© Springer-Verlag 2007

Authors and Affiliations

  1. 1.Accounting and Finance GroupManchester Business School and Collegio Carlo Alberto (CeRP)ManchesterUK
  2. 2.Faculty of EconomicsUniversity of Turin and Collegio Carlo Alberto (CeRP)TurinItaly

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