Comparing the historical performance of the large- and small-cap segments, Figure 2 exhibits the risk and return patterns over the last 10 years for global and regional Provisional MSCI Standard and Small Cap indexes over different time horizons from a U.S. dollar perspective.

The Provisional MSCI Small Cap Indices outperformed their standard index counterparts at higher risk levels, resulting in higher risk adjusted performance for most small-cap indexes over the three time periods studied.4

A closer look at the performance over the last 10 years reveals that timing seems important when allocating assets between small- and large-cap investments. Figure 3 plots the cumulative performance over the last 10 years for the Provisional MSCI EAFE Small Cap Index and the Provisional MSCI EAFE Standard Index. The recent performance explains why demand in international small-cap has increased dramatically over the last five years. It is also worth mentioning that the two indexes moved up in lockstep over the last four years, suggesting an increase in correlation.

This historical risk and return comparison indicates that small-caps offer a different return profile at a higher level of risk. The increased risk relative to the standard index is highlighted by the extended underperformance in the late 1990s as well as the outperformance during the recent bull market. This return pattern also existed at the regional level.

Figure 4 plots the performance of the USA, Asia Pacific and Europe Provisional MSCI Small Cap indexes relative to their respective Provisional MSCI Standard indexes. In this comparison, both the U.S. and Europe show a significantly different performance profile relative to their standard indexes. The chart also highlights a global size effect across regions as all three small-cap indexes underperformed their standard counterpart in the 1990s and outperformed in the 2000s. Beyond the risk-return characteristics of the small-cap segment, it is also important to understand how much diversification the small-cap allocation provided during this period. Figure 5 exhibits the 36-month rolling correlations between the Provisional MSCI USA Standard Index and select regional Provisional MSCI Small Cap indexes. Since the late 1990s, the correlation between the Provisional MSCI Europe Small Cap Index and the Provisional MSCI USA Standard Index has risen from a low of around 20 percent in 1998 to almost 85 percent in 2005, settling in May 2007 slightly above 70 percent. The MSCI Pacific Small Cap Index has moved in the opposite direction since 2000, offering significant diversification benefits at recent levels of 15 percent to 35 percent. By analyzing the relationships across individual markets, we have shown in previous research that country correlations have not increased as much as they have at the regional and global level.5 We looked at the trend in small-cap country correlations to the Provisional MSCI USA Standard Index over the last 10 years.6 Figure 6 shows the average small-cap country index correlation with the MSCI USA Standard Index and the range of small-cap country index correlations around the average from May 1997 to May 2007. Based on Figure 6, the average individual country correlation has not changed significantly over the last 10 years, staying near 50 percent; however, the gap between the highest (Europe) and lowest (Japan) correlation widened from around 15 percent in 2001 to close to 60 percent in May 2007. These results indicate that country allocation played a significant role in achieving diversification benefits during this period. However, the diversification benefits at the aggregate index level were limited, with the exception of Asia and, in particular, Japan. Drivers Of Returns In International Small Cap Understanding the source of return in international investing is an important element in deciding on the type of investment process one might implement. In case the variation in return is driven by differences in country weights, the asset owner may want to select an asset manager who pays significant attention to country allocation. If, on the other hand, the majority of the difference in returns can be explained by a larger dispersion of idiosyncratic or company-specific returns across the small-cap universe, stock selection may be more relevant. In such an environment, the country and sector allocation decision may be secondary to a bottom-up investment process. To get a sense of the different return characteristics of international small-cap and the standard-cap segment, we compare the cross-sectional return dispersion (CSV) across the Provisional MSCI EAFE Standard Index and the Provisional MSCI EAFE Small Cap Index constituents.7 Cross-sectional volatility measures the dispersion of stock returns at one point in time:

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