Is Dispersion in Small Caps Linked to Selection Opportunities?

In principle, high dispersion in stock returns should create opportunities for active managers. One measure of stock dispersion is cross-sectional volatility (CSV). CSV is defined as the standard deviation of returns across stocks in a specific universe over a defined period. CSV has been viewed as a proxy for active managers’ potential to add value through their stock-selection process. For example, when stock-return dispersion, measured by CSV, has been low, stock prices have behaved similarly and offered fewer opportunities for active managers to outperform the market.

Our analysis, from 2002 through the third quarter of 2023, shows that across regions, as represented by the MSCI USA, MSCI World ex USA and MSCI Emerging Markets Indexes, CSV was higher in small caps compared to the larger-cap stocks in the parent indexes. Our finding indicates greater potential for active managers’ stock-selection strategies to bear fruit in small-cap stocks versus the large-cap and midcap segments of the equity markets.

We refined our assessment by stripping out systematic factors, such as style, country and industry, from the CSV calculation to derive a stock-specific CSV. The contribution of stock-specific CSV as a percentage can proxy the potential added value from security selection alone. In each region, we observed that stock-specific CSV has been higher for small caps than midcaps and large caps, indicating potentially more stock-selection opportunities for active managers within the small-cap segment.