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Since Rolf Banz introduced the idea that small companies outperformed large companies in 1981, the ‘size premium’ has been widely studied, particularly in the U.S.

The following data are from the Center for Research in Security Prices (CRSP) for January 1926 through September 2011.

Large

Mid

Small

Micro

Risk Free

CRSP 1-2

CRSP 3-5

CRSP 6-7-8

CRSP 9-10

1 Mo US Bills

Return

9.14%

10.76%

11.13%

11.83%

3.59%

Volatility

18.00%

22.62%

26.64%

32.74%

0.87%

Sharpe Ratio

0.31

0.32

0.28

0.25

-

What we can see from the data is that returns are higher as company size gets smaller. Since there’s no free lunch, the level of volatility increases as well. The Sharpe Ratio divides excess return (the index return minus the risk free rate) by volatility to see if the extra risk is compensated for by excess returns. In the U.S., the highest Sharpe ratio belongs to mid-cap stocks.

If you believe that the extra return is compensation for the additional risk of owning small and midsize companies, then it’s logical to think this theory would apply overseas, too. The data in Emerging Markets haven’t been tracked for long enough to say with statistical confidence that the size premium exists, but the data thus far are encouraging.

While not statistically significant because of the lack of historical data, a simple real world test is a comparison of DFA Emerging Markets Small Cap fund (DEMSX) with the Vanguard Emerging Markets Stock Index fund (VEIEX). According to Morningstar, for the 10 years ending Dec. 7, 2011, DEMSX earned four percentage points per year more than VEIEX.

With 56 Emerging Markets ETFs in the ETFdb list, only three are broadly diversified small-cap funds: the SPDR S&P Emerging Markets fund (NYSEARCA:EWX), the WisdomTree Small Cap Dividend fund (NYSEARCA:DGS) and the iShares Emerging Markets fund (NYSEARCA:EEMS). To date, there is only one mid cap emerging markets fund. It comes from IndexIQ and is listed under the ticker EMER.

In my view, investors are well served to diversify by size domestically, in developed markets and in emerging markets. Furthermore, investors are likely to be better off with large-, mid- and small-cap exposure rather than just large and small because this should make it possible to get a size premium similar to small, but in a more diversified way.

Now could be a particularly good time to consider mid- and small-cap exposure in emerging markets. With large-cap emerging market stocks still down more than 20 percent from the high, diversifying now is likely to reduce the tax burden of any transactions.

Disclaimer: The views expressed do not necessarily represent the views of Acropolis Investment Management, LLC. or its members.

Source: Is Mid Cap The Sweet Spot In Emerging Markets?