This paper will be presented at the 2017 Northern Finance Association Conference being held in Halifax, Nova Scotia from September 15-17. Canadian Investment Review is proud to be a media sponsor for this event for the third year in a row.
The premise for investing internationally is typically driven by the benefits that diversification offers to an investor. Constructing a portfolio with foreign indices has both traditionally increased total returns and decreased volatility. There has, however, been a well-documented trend of increased dependence between international equity markets. This recent regime of increasing asset co-movement has called the concept of diversification into question, which in turn, has given more ground to motivate a tilt in asset management mandates toward domestic investments.
In our recently released working paper, we confirm that correlation between international equity indices has trended upward. But we simultaneously document a rich dynamic around this trend. While it is clear that for a buy-and- hold US investor, the average correlation can be viewed as a reasonable statistic that characterizes the benefits of international diversification, the same cannot be said for an investor who rebalances her portfolios to benefit or hedge against these time variations in assets co-movements.
Portfolio allocations that consider only the average correlation level embedded in the data are sub-optimal and consequently lead to more domestic investment decisions if correlation levels are high. Importantly, diversification benefits can arise from an alternative source to return correlations: correlations between higher-order moments of international index returns are typically very low on average.
Dynamically rebalancing a portfolio towards assets with more favorable higher moments than the domestic portfolio gives rise to substantial economic gains from investing abroad.
In our paper, we show that there are still significant diversification benefits, even within a trending correlations regime for international equities from the view of a US investor. We show that in order to capture these diversification benefits, an investor needs to (1) account for higher-moment co-movement between the assets in her portfolio while factoring in the risk of joint decline across markets and (2) depart from the traditional buy-and- hold and mean-variance setup and solve for the optimal portfolio in a way to capture and hedge this rich dynamic.
The rationale behind our first finding stems from the fact that while unconditionally extreme declines in international stock markets tend to occur simultaneously, there still remains a substantial diosyncratic component in the country-specific skewness or measures of asymmetry in the return distributions of the equity indices of individual countries. Cross-country skewness correlations are positive but typically low and only a small proportion of country’s equity index skewness can be attributed to general market trends. Thus, benefits from including a foreign asset in the portfolio stem from dynamically adapting the portfolio mix towards assets with less negative skewness.
Second, we investigate the portfolio response to those time-varying features of asymmetry in the international stock return distribution. A mean-variance portfolio investor benefits less from investing in a foreign asset mainly because she fails to exploit the dynamics of higher moment asymmetries. An investor who registers such asymmetries but builds her portfolio based on one-period- ahead expectations of the return distribution gains less from diversifying internationally since she fails to hedge her portfolio position against changes in the investment opportunity set manifested by varying degrees of co-movement between the assets in the portfolio and varying levels of conditional asymmetry of the individual assets.
Over a long-term horizon, a dynamically hedging investor would require substantially higher initial wealth than a static investor in order to render her indifferent between holding the home asset and investing internationally.
We find that the loss of benefits from diversification and dynamic hedging together is three times higher on average than the loss of benefits from mean-variance diversification alone.
Prior literature has shown that naïve diversification, or equally weighting assets in the portfolio, tends to outperform standard mean-variance optimization out-of- sample. Estimation error can offset any gain from optimal mean-variance diversification.
However, in our paper we show that the benefits from dynamic hedging overweigh potential losses that may stem from estimation errors. We find consistent evidence across all pairs of equity indices of substantial gains from optimally diversifying with a foreign asset. As well, naïve diversification is costly.
An investor who diversifies by allocating equal proportions of wealth to each foreign asset would need 70% more initial wealth in order to be indifferent to hedging dynamically against changes in the investment set over nine years.
We think that our results have implications for portfolio management in the context of international diversification, especially for long-term investors. In the case of pension funds for example, the level of international diversification to foreign equities is considerable on average (with about 35% invested in assets abroad) but shows a substantial cross-sectional variation. While the size of the domestic market and regulatory policies may stay behind the significant differences in foreign investment of pension funds across countries, our paper offers a methodology to assess the benefits from investing abroad from the viewpoint of a domestic fund over a long investment horizon.
You can read a full version of this paper on the Northern Finance Association Conference website.
This paper will be presented at the 2017 Northern Finance Association Conference being held in Halifax, Nova Scotia from September 15-17. Canadian Investment Review is proud to be a media sponsor for this event for
the third year in a row.