Does the Size Premium Apply to Countries? via Gerstein Fisher

Since 1981, the “size premium,” or the tendency for smaller-capitalization securities to outperform their larger-cap counterparts, has been extensively documented in financial literature in the United States.[1] Some studies have extended this research and reported that the size effect applies for country indices as well. Gerstein Fisher conducted research on the relationship between aggregate country equity market capitalizations and country-level market index returns and explored how a market-cap weighted international portfolio can be improved by limiting the weight of larger countries, such as Japan and the United Kingdom, and redistributing weights to smaller countries.

For our study, we examined a capitalization-weighted basket of developed-market country indices (excluding the US) that resembles the MSCI EAFE Index. We used this index as our benchmark, and have reported country component weights of this index in the right-most column of Exhibit 1. We then limited the maximum weight of any one country in the portfolio (ranging from a 10% cap to 15%) and re-distributed that weight to all other countries according to their market capitalizations. If, after the re-allocation, any country exceeded the maximum portfolio weight, we repeated the process and re-allocated the additional weights.

Exhibit 1, which provides the average exposures of each country in the various country-capped portfolios and the benchmark over the sample period from January 1997 to July 2015, shows that this process generally reduced the weight of the two largest countries, Japan and the United Kingdom, and added the most weight to the larger of the smaller countries–France, Germany, Switzerland and Australia—resulting in a more even distribution of country weights in the modified portfolio.


Exhibit 2 reports the performance of our strategy on a cumulative and annualized basis relative to the benchmark; Exhibit 3 shows results on a cumulative basis over time. As shown in both of these exhibits, all of the capped approaches have achieved modestly better cumulative and annualized returns compared to the benchmark over the period from January 1997 to July 2015. Note that this outperformance is achieved with higher volatilities (as measured by annualized standard deviations). The highest volatility (18.45 %) is observed for the portfolio applying a 10% country-weight limit and the lowest (17.92 %) for the portfolio applying a 15% country-weight limit, compared to 17.14% for the benchmark. Despite the higher volatilities, all capped approaches delivered better risk-adjusted performance as measured by Sharpe ratios[3] (ranging from 0.345 to 0.373), compared to the Sharpe ratio of the benchmark (0.304).

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Without further research, we can only speculate about what causes the “small country effect”. The higher return may be explained by the tilts towards the value factor: we have assigned greater-than-market weights to stocks with high fundamentals relative to price and less-than-market weights to stocks with low fundamentals relative to price at the country level in the form of country max limits since smaller countries tend to have higher growth potential and less expensive equity markets. For example, Japan, a country with a relatively low dividend yield, sees its weight in the country-capped portfolios decrease by a range of 9% to 14% with respect to the benchmark.

There is a trade-off associated with tilting toward small countries, however, by using this technique. The increased volatilities indicate that small markets are riskier than larger ones. But the increase in volatility is limited since by applying a max-country weight strategy we limit the portfolio’s exposure to any single country, thus enhancing portfolio diversification and lowering concentration risk. Overall, a max-country weight strategy suggests a potential robust portfolio construction methodology that could improve the portfolio’s risk-adjusted performance, as shown by increased Sharpe ratios compared to the benchmark.

For more detail and the full results of our study, we invite you to read our research paper, Country Size Premiums and Global Equity Portfolio Structure.


Our research points to a possible methodology to better structure a multi-country portfolio:  varying allocations to different countries based on their equity market capitalizations. As we show, re-distributing some of the weight of larger countries to smaller countries can improve an international stock portfolio’s risk-adjusted performance.



[1] See, for example: The Relationship Between Return and Market Value of Common Stocks, Rolf W. Banz, Journal of Financial Economics, 1981. [2] Only countries with weights changed are presented.  [3] The Sharpe ratio is equal to the excess portfolio return (above the risk-free rate) divided by the standard deviation of the excess portfolio return.