Abstract

The behaviour of small caps in emerging markets has not received much attention in the academic literature. For international investors, they pose particular problems to the extent that their returns reflect political risks, and fiscal and monetary instability that give rise to inflationary pressures. This paper looks at the diversification benefits of small cap returns across emerging market countries, taking into account their exposure to inflation. The paper finds that for many of the countries with lower-than-average inflation, adding their small cap stocks to a benchmark US large-cap portfolio expands the mean variance frontier of the benchmark portfolio. This finding is robust to the effects of the Global Financial Crisis to an extent. Diversification benefits of small cap stocks are rare for emerging countries with higher inflation, and not seen at all for the post GFC period.