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International Equity Diversification: Small-Cap Versus Small-Market Effects

Increasing correlation among international equity markets has prompted investors to seek new investment opportunities. To shed light on this issue for U.S. investors, this paper measures economic benefits of international equity diversification using mean-variance and higher-moments frameworks and tests their significance across a broad spectrum of stocks in 63 developed, emerging, and frontier markets from January 1997 to June 2010. The focus is on examining the small-cap versus small-market effects by creating ranking variables representing market size and stock size. This paper finds the presence of economic benefits, indicating potential risk reduction or broader investment opportunities. These benefits tend to be negatively correlated with market size or stock size, with market size tending to be stronger. Small-cap indexes in smaller emerging markets and frontier-market indexes yield higher benefits. Finally, diversification benefits existed during the 2000-2003 and 2007-2010 crisis periods, highlighting the importance of the ability to forecast asset return moments.