Diversifying with Small Caps

When investors are considering adding new types of investments to their portfolios, they examine not only the risk and return profiles of those new allocations, but also whether they might add diversification benefits. They do this by examining the correlations between the old and the potential new components: Did returns move in the same direction over time or have they exhibited a differentiated return pattern? The correlation measure ranges from -1 to +1; the closer it is to +1, the more correlated the investments being measured.

Looking at the 5-year rolling correlations between regional indexes and their small-cap counterparts, we note that the correlations were positive across all regions for all periods. This is not unexpected given these are all equity indexes and each set shares common return drivers, including geographical exposures. It’s also important to keep in mind that there are no overlaps (common constituents) between the regional and small-cap indexes and no “gap in coverage.” (Together they cover 99% of the global equity investment opportunity set.)

If we look a little bit deeper, however, we can see that not all regional indexes were correlated to their small-cap counterparts at the same level and correlations changed over time (see exhibit below). While the MSCI Emerging Market (EM) and MSCI EM Small Cap Indexes’ correlation was more stable and always hovered around 0.95, the correlation between the MSCI Europe and MSCI Europe Small Cap Indexes showed a wider range and declined nearly to 0.80 at points.

Broadening our survey to correlation levels between the MSCI World Index and the regional small-cap indexes, we see on the second chart that, again, all are positive and always below +1 for the whole period, with the MSCI EM Small Cap and MSCI Pacific Small Cap Indexes exhibiting the lowest correlation figures.

Despite some differences in correlation levels and consistency, the fact that all correlation levels we saw were below +1 shows there were potential diversification benefits from adding a small-cap allocation to regional or global portfolios.