Should managers ti lt to small-caps ? Factors such as investor sentiment, improving economic conditions, interest rate and inflation expectations, improving credit conditions and attractive valuations of small-cap shares relative to large-cap shares may signal periods when small-cap shares may outperform large- and mid-cap shares. Using these and other indicators of potential small-cap outperformance, it is difficult to consistently outperform by varying the short-medium term allocation to global small-caps. In his discussion of the factors that drive the relative performance of small-caps Pradhuman (2000) notes: “Although evidence suggests the existence of factors or relationships that might cause one to lean toward smaller or larger firms, efforts at market-timing the size or small-cap turns can nonetheless be humbling”. According to Damoderan (2003), while there is definitely a small-cap effect over the long-term, for periods less than five years, small-caps outperform large- and mid-caps about 50 per cent of the time, meaning that the relative outperformance of small-caps against large-caps is essentially random. However investing in small-caps for periods beyond five years results result in small-caps winning decisively.

Do global small caps improve portfolio diversificati on? The benchmarks for global small-cap shares all exhibit a country and sector weight profile different from the equivalent largeand mid-cap benchmarks. The index is overweight in the industrials and consumer discretionary sectors, which are more oriented toward domestic demand. This is consistent with the observation that small-caps tend to be regionally focused rather than globally focused companies. Also the index is underweight the consumer staples, energy, and telecommunication services sectors. This is consistent with the observation that these sectors are generally dominated by larger companies that can extract economies of scale in their operations. Furthermore, performance within each sector can be significantly different between large- and small-caps. These differences in sector and regional weights between the global small-cap shares and global largeand mid-cap shares may improve the diversification of a global equity portfolio. Why small-cap managers should outperform the index The potential for an active investment manager to outperform a benchmark can be measured by calculating the cross sectional volatility (CSV) of the benchmark. All other things being equal, higher CSV/lower correlation between shares should result in greater opportunity for active management to add value. Figure 5 below shows the cross sectional volatility for developed (MSCI World) and emerging market (MSCI EM) large- and mid-cap indexes, and developed and emerging market small-cap indexes. As figure 5 shows, the CSV – the size of opportunity for active investment management to outperform – of both developed and emerging market small-caps is consistently higher than the CSV of the standard (large- and midcap) indexes. This suggests that there may be more opportunity for active investment managers to outperform their benchmark by using bottomup stock selection (i.e. where active management focuses on company fundamentals or the factors that make one company different from another) to identify appealing small-cap shares. Is activ e outp erforma nce consistent?