A Review of International Portfolio Diversification.docx

A Review of International Portfolio Diversification.docx

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AReviewofInternationalPortfolioDiversification

AReviewofInternationalPortfolioDiversification

Contents:

1.Introduction2

2.Basicrationaleforinternationalportfoliodiversification2

2.1Markowitz’stheoreticalsupporting3

3.Acomprehensiveinsightintointernationalportfoliodiversification4

3.1Fromtheperspectiveofinter-countries4

3.2Fromtheperspectiveofportfoliocomponents5

3.3Fromtheperspectiveofothers6

4.Conclusion7

Reference9

Wordsaccount:

1985

AReviewofInternationalPortfolioDiversification

1.Introduction

Internationalportfoliodiversificationhasbeenacontroversialissuecurrentlywiththeprominentrevolutiontakenplaceintheglobalfinancialworld.Manymodelsareputforwardconsecutivelytoillustratetherationaleofinternationalportfoliodiversificationandtherefore,manyscholarsareinfavorofthebenefitsbroughtbyinternationaldiversificationonthebasisofitseconomicprinciples.Nevertheless,thetheory’sopponentsarearguingthatthemassivetransactioncost,managerialtuitionandincreasinglyintegratedmarketshavebecometheoverwhelmingbarriersconstrainingtheacquiringofbenefits.

Hence,thispaperaimstogainanobjectiveinsightintothebenefitsbroughtbyinternationalportfoliodiversificationthroughasynthesisofliteraturereview.Theremainderofthisessayconsistsof3sections.Section1willfocusontheanalysisofthebasicrationaleandprinciplesintermsofhowinternationalportfoliodiversifyriskandsection2isgoingthroughtheempiricalevidenceonboththebeneficialimpactsanddetrimentalinfluencesofinternationalinvestmentdiversificationwithacomparableclarificationamongdifferentcountries,specificportfoliocomponents,differenttimeperiodandsomecertainconstraintsrespectively.Thelastsectionprovidessummariesandconcludingremarks.

2.Basicrationaleforinternationalportfoliodiversification

Asthefatherofmodernportfoliotheory,Markowitz（1952）hasintroducedthe“PortfolioTheory”inhisPortfolioSelectionoriginally.Thispath-breakingstudyillustrateshowthewell-knownE-Vrule（Expectedreturn-Variancerule）canbeusedtoreducethediversifiableriskinselectingoptimalsecuritycombinationsundersomeassumptions.Actually,beforethebirthofPortfolioTheory,Hicks（1939）’sRiskCompensationandWilliam（1938）’sDividendDiscountModelhavealreadyillustratedtheconceptofdiversifiedinvestment.Additionally,Marschak（1938）andLeavens（1945）alsodenotedthatpeopleprefertochoosethehighreturn-lowriskyinvestmentproductsandthebenefitsofdiversifiedinvestmentrespectively.ButitisMarkowitzwhoclarifiesthedetailedconductionofportfolioinvestmentclearlyandafterthat,manydifferentinvestmentportfoliomodelshavebeenproposedbysuccessorsstepbystep.

2.1Markowitz’stheoreticalsupporting

ThequadraticprogrammingmodeldevelopedbyMarkowitzquantifiesreturnandriskofasecuritybythemeasurementofitsexpectedreturnandstandarddeviation.Themainpointisthatinvestorsshouldconsiderreturnandrisktogethertodeterminetheallocationoffundsamonginvestmentalternativesonthebasisoftheirreturn-risktrade-off（Kolmetal.,2014）.

Asfortherationalefortheriskdiversification,supposingtheweightinaportfolioisequaltoeachother,sotheportfoliovarianceis（notes:

alltheformulasprovidedbyEdwinJ.Elton（2011））:

（2-1）

Definetheaveragevarianceandcovariance:

（2-2）

（2-3）

Thenwegotthevarianceofportfolio:

（2-4）

Supposethatallthesecurities’standarddeviationis

thecorrelationcoefficientbetweenallthesecuritiesis

:

（2-5）

Itisdemonstratedthat

hasapositiverelationshipwithportfoliovariance,whichmeansthatthelessthecorrelationis,thebettertheportfoliodiversified,formingthecornerstoneofmoderninternationalportfoliodiversificationtheory.Sincethefundamentalprinciplesoflaterdevelopedmodelsaresetuponthesimilarrationale,includingAPT,CAPM,ICAPM,Single-indexModel,TwoFundSeparationTheorem,FF3Modelandsoforth（Tobin,1958,Sharpe,1964,Sharpe,1963,Lintner,1969,Mossin,1966,Ross,1976,R.French,1996,Merton,1973）,therefore,thispaperdoesnotmakeanystatementabouttheirworkingrulesclearly.

WiththebirthofMarkowitz’sE-Vrule,itisthereforeconvincedthattheincrementalnumberofportfoliosecuritiesisbenefittothereductionofthehighlydiversifiedunsystematicrisk（Grubel,1968）.Substantialresearchers,howeverholdthecompletecontrastopinion,demonstratingthatinternationalportfoliodiversificationtheoryisnotalwaysbringingaboutpositivebenefitswithoutanynegativeeffectsinitsexpectedreturnsanditisnotacceptabletolookonlyattheconstantcorrelationsbetweensecuritiessimply（YouandDaigler,2010）.

Admittedly,Markowitz’sclassictheoryshouldbetreatedunbiasedregardlessofitsindeliblecontributiontothematurityofmodernportfolioroad.Intherestingpart,massivedifferentviewpointsaboutinternationalportfoliobenefitswillbecomparedanddiscussedcomprehensively,aimingtoofferasynthesizedsighttoalltheaudience.

3.Acomprehensiveinsightintointernationalportfoliodiversification

3.1Fromtheperspectiveofinter-countries

OneoftherepresentativeearlierstudiesonthebenefitsbroughtbyinternationalportfoliodiversificationisGrubel’sresearch（1968）.Withtheassistanceofasimplemacroeconomicmodel,Grubeldrawsuptheconclusionfroman11countries’monthlydata,rangingfrom1959to1966,thatpotentialbenefitsareavailableintheinternationalportfoliodiversification.Levy（1970）hasalsoacquiredasimilaroutcomewitha28countries’indices,whilethisstudyalsopointsoutthatsubstantialgainsaremorepossibletowinindevelopingcountries,achievingawidelyacceptanceamongmassivesuccessors（Ibrahim,2006）.Nevertheless,thisviewpointhascausedaseriesofbittercontroversyinthelaterseveraldecades.

Manystudieshaveprovidedsufficientevidenceontheobtaininglargestinternationaldiversificationbenefitsonlyinemergingmarkets（BekaertandHarvey（2011）,DeJong（2005）,Errunzaetal.（1992）,DriessenandLaeven（2007））.Themainreasonforthisconclusionisthemoreevidentmarketintegrationinthedevelopedcountries（Chiou,2008）.DeRoon,NijmanandWerker（2001）evendenotethatinternationaldiversificationbenefitsaresmallerforinvestorsinUSvis-à-vistheircounterpartsinless-developedmarkets.Despitethat,Chiouetal.（2009）documentthatdiversifyingportfoliosinternationallyisstillbeneficialeventhoughfinancialmarketsarebecomingmorecorrelated,whichissupportedbythestudiesofCampbelletal.（2001）andHentschelandLong（2003）.AccordingtoEunandResnick（1994）,itisdemonstratedclearlythatthepotentialgainsfrominternationaldiversificationaremuchgreaterforUSinvestorsthanEastAsianinvestors.Moreover,Odier（1995）evenarguedthathigherreturnsofferedbymanyemergingmarketscomingwithhigherlevelofmarketvolatility,supportingthatthebenefitsindevelopingcountriesareoverestimatedslightly.

Overall,itisgenerallyagreedthattheexistenceofanunstablecorrelationstructuremakesitdifficultforinvestorstodiversifytheirportfolioandtherefore,theinvestorsarenotabletotakefulladvantageoftheentireinternationalportfoliomarket（Shawkyetal.,1997）.

3.2Fromtheperspectiveofportfoliocomponents

Turningtotheissueofportfoliocomponent,threeeffectivemeansforindividualstoobtainpotentialinternationaldiversificationbenefitsareFOHFs,ADRsaswellasInternationalMutualFunds.

FOHFs,theabbreviationforFundsofHedgeFunds,isreputedaslowercorrelationswithstockindicesinbothbearandbullmarkets（DenvirandHutson,2006）.SinceFOHFshavemoredesirablecorrelationswiththeS&P500comparedtothehedgefundindex,soitcanbeefficientinamelioratinghedgefund’sperformance,especiallyduringthemarketdownturnsandfinancialcrisis（Jaffer,2003）.Whereas,FOHFs’investorshavetopaymoremanagerialtuitionsthanthetraditionalhedgefunds,insomecases,evenhigherthanthetotalexpectedreturnintheinvestmentactivities（Lee,2012）.Besidesthat,itisdoubtedthatthereturnsannouncedbyFOHFswerenotnormallydistributedwithexcesskurtosisandnegativeskewness,severelyunderestimatingtheactualrisklevel（Agarwal（2004）,（KatandAmin,2002）,（FungandHsieh,1997））.

AsfortheADRs（AmericanDepositoryReceipts）,MaduraandO'Brien（1991）regarditasthemostefficientselectionforinvestorstoriskdiversification.Earliertothat,Officer（1987）hasclaimedthatcombinedportfoliosofADRsandUSstocksillustratesignificantlylowervariancethanportfoliossimplyconsistedofUSstocks.Tucker（1987）furtherstatesthatthemarginalbenefitsbroughtbyADRsissimilartotheentireforeignstocks.However,thelimitedavailablenumberofADRsandthecostsofADRs’transactionmayplaceabarrierontheinvestors’preferencetothisportfolioselection（MaduraandO'Brien,1991）.

InternationalMutualFundsisanotherareaforconsiderationvis-à-visthebenefitsofinternationalportfoliodiversification.TheearlierresearchofEssayyadandWu（1988）assessthediversificationattributionof18InternationalMutualFundsoverthe1977-1984period,discoveringthat15offundshavehighermeanreturnand16ofthemhavelowercoefficientofvariationthanS&P500.Additionally,RaoandAggarwal（1987）testthatthefund’sestimated

waslessthan

andonly

ofthevariationineachfund’sreturncouldbeexplainedbymarketmovements,showingtheevidencethatInternationalMutualFundsarenot