Information spillovers and size-sorted portfolios: structural evidence from Australia

A portfolio of small capitalization stocks formed from securities listed on the Australian Stock Exchange (ASX) fails to adjust to market-wide news instantaneously and displays a significant amount of predictability from lagged returns on large and medium size firms. Despite apparently large excess payoffs generated by filter rules, the lagged adjustments become economically insignificant once transaction costs associated with taking a position in each constituent security are taken into account. I suggest that the observed predictability is largely due to a lack of small cap portfolio derivatives which could facilitate index arbitrage and enhance price discovery in the Australian market.