Portfolio Design: A Modern Approach to Asset Allocation

LARGE-CAP AND SMALL-CAP STOCKS IN A PORTFOLIO CONTEXT

The analysis so far has not considered the role of small-cap stocks within a portfolio with both bonds and stocks. It’s useful to consider the returns of small-cap stocks by themselves or relative to large-cap stocks. But most portfolios also have significant holdings of bonds, so the performance of small caps in a portfolio of stocks and bonds is therefore of interest. This section will consider small-cap performance in portfolios that have 30 percent invested in bonds and 70 percent in stocks.

The first set of portfolios will be based on Russell data for small caps and large caps. Recall that small caps as represented by the Russell 2000 index did not outperform large caps either in terms of returns or risk-adjusted returns. Nonetheless, it’s entirely possible that small-cap stocks could perform well in a portfolio consisting of bonds and stocks depending on the correlations among the asset classes. To examine this possibility, we will consider a three asset portfolio consisting of large and small-cap stocks, represented by the Russell 1000 and 2000 indexes, and bonds, represented by the Barclays Capital Aggregate Bond Index. As an alternative to this portfolio, the Russell 2500 small/mid-cap index will replace the Russell 2000 small-cap index.

Table 3.9 reports the returns and risks of each asset for the period from 1979 to 2009. The table also reports the correlations among the asset classes. The correlation between large-cap ...