The level of return dispersion within a segment or asset class suggests certain investment processes may be more appropriate for some managers than others. For example, managers investing in an asset class with high return dispersion may argue for active management. On the other hand, an asset class with little return dispersion may be better served with an effective passive investment process, as it is much harder to generate active performance over the benchmark.8

Figure 7 displays the rolling 12-month cross-sectional volatility of the constituents of the Provisional MSCI EAFE Standard and MSCI EAFE Small Cap indexes from May 1995 to May 2007. The small-cap index constituents experienced a level of return dispersion 50-to-90 percent higher than the standard index constituents.

This result shows the impact that picking the right (or wrong) stocks can have on the performance of small-cap portfolios. However, more factors can be considered before deciding on the investment process for an international small-cap manager.

Next, as part of this analysis, we identify where the significant difference in stock level CSV is coming from, as this provides an indication of the main drivers of returns. Potential reasons include varying exposures to common sources of return; for example, country, sectors and styles such as size, value or growth. In contrast, the difference may also come from company-specific or idiosyncratic variations between the two size segments.

Intuitively, one might expect company-specific CSV across small caps to be significantly larger, as small caps commonly only offer a limited number of products or services. In these cases, the success or failure of a single product will have a larger impact on a company's success. Figure 8 confirms the intuition: The majority of the difference in return dispersion between the constituents of the standard and small-cap indexes comes from company-specific performance. These results provide a quantitative explanation for why the small-cap space has been traditionally associated with fundamental stock picking. As a consequence of the higher CSV within small caps, asset managers might consider a potentially different investment process for the international small-cap segment.

So far we have looked at CSV across individual securities and have seen that the return differences within the Provisional MSCI Small Cap universe are significantly higher than within the Provisional MSCI Standard universe. However, in a diversified portfolio, company-specific variations diversify away and systematic return factors such as countries, global sectors, and styles, become more dominant. We therefore want to understand the contribution of the different global components to the global CSV of the small-cap segment. If return differences across countries are significantly larger than differences across global industries, the country allocation decision ought to play a bigger role in portfolio performance relative to global sector allocation decisions. Figure 9 shows that the country dimension of the Provisional MSCI EAFE Small Cap Index dominates industry and style dispersion, with roughly 60 percent of the global CSV component explained by return dispersions across countries as of May 2007. This result highlights yet another difference from the large- and mid-cap segment, where many see the sector allocation decision as equally (if not more) important than country allocation. Figure 10 illustrates this point, showing that industry contribution to global CSV for the constituents of the Provisional MSCI EAFE Standard Index is recently equally important to the country contribution.9 Going beyond the initial results on correlation at the aggregate index level, the CSV analysis exposes the main difference between size segments during this period and supports the argument to have treated small-cap as a separate asset class. The small-cap segment exhibited significantly larger return dispersion with direct implications for the investment management process. A study by Callan Associates confirms our findings: Observed risk and return behavior within the Callan International Small Cap style group has varied widely. In fact, this asset class produces more dispersion in historical performance than even emerging market equities.10 Active Versus Passive—Practical Considerations In this section, we consider some implementation challenges within the international small-cap segment and balance the arguments for active and passive investing. So far, international small-cap mandates have largely been active and managers were expected to consistently outperform their respective benchmarks. As always, the question remains whether it can be done consistently on an ongoing basis. Recent surveys by InterSec state that many active strategies have run into capacity constraints and a number of the historically successful international small-cap products have been closed to new investors. Another noteworthy point of InterSec's study is that almost 60 percent of the open small-cap funds have performed below the median product over the last three years.11

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