To the extent that investors diversify internationally, large-cap stocks receive the lion’s share of fund allocation. Increasingly, however, large-cap stocks or stock market indices tend to co-move, mitigating the benefits from international diversification. In contrast, stocks of locally oriented, small companies do not exhibit the same tendency. In this paper, we assess the potential of small-cap stocks as a vehicle for international portfolio diversification during the period 1980-1999. To that end, we form and utilize three market cap-based index funds, i.e., large-, mid-, and small-cap funds, from each of our sample countries. The key findings of our paper include: First, small-cap funds cannot be ‘spanned’ by stock market indices or large-cap funds. Further, international small-cap funds have relatively low correlations not only with large-cap funds, but also with each other. Thus, international diversification would be more effective with a combination of large- and small-cap funds than with large-cap funds alone. This can justify the recent proliferation of small-cap oriented international mutual funds in the U.S. Second, the optimal international portfolio tends to comprise the U.S. market index and foreign small-cap funds; neither foreign market indices nor mid-cap funds receive positive weights during our sample period. The extra gains from the augmented diversification with small-cap funds are statistically significant unless additional transaction costs for small-cap funds become excessive.
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