FIN 408 International Investment

Factors affecting Risk and Return Size and Number of International Open-end Funds Global market Correlations  Correlation over time - constant vs. non constant  Implications on portfolio diversification Gains from International Diversification.

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Factors Affecting Risk and Return

Returns  World Bank projects that 70% of the growth of the world’s real GDP during the next 20 years will come from developing economies in Asia, Latin America, Eastern Europe and Africa  January 1987 to may 1993: Stock market growth in Turkey 637%; Argentina 1,374%; Mexico 960% (Source: Investor’s Guide to Emerging Markets).

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Factors Affecting Risk and Return

 There are more people abroad whose incomes are growing faster (China , India, for example)  Vast need for infrastructure and technology investment in the emerging economies Risks Faced by International Fund Managers  Currency Risk- pegged to US $, mitigates risk if invested in single country; hedge currency exposure.

 Political Risk - nationalization  Inadequate Accounting  Liquidity problems 3

Factors Affecting Risk and Return

 Legal and Regulatory Risk  Higher costs - market less efficient, higher transaction cost, fund manager incur additional travel costs etc., Size and Number of International Open-end Funds  1990-99: Global/International Mutual Funds assets grew from $46.2b to $501.4b

 Cash flow into international funds in 2000 was $49.9b.

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Why Invest in International Funds

Why Invest in International Funds?

 Diversification benefits;  Fund managers may earn abnormally high returns because of market inefficiency; 5

Global Market Correlations

Global market Correlations  Correlation over time - constant vs. non constant;  Correlations between developed markets;  Correlations between emerging markets;  Implications on portfolio diversification 6

Global Market Correlations

Correlations / Diversifications with ECM:

1985-95: Correlation = .34

 ECM had higher return and higher risk than S&P 500  S&P 500 is not on the efficient frontier  Minimum Variance Portfolio contained 20% ECM 7

Global Market Correlations

1975-95: Correlation = .27

 ECM had lower return but higher risk than S&P 500  Minimum Variance Portfolio contained 30% ECM

1990-95: Correlation = .41

 ECM had lower return but higher risk than S&P 500  Minimum Variance Portfolio contained 10% ECM 8

Characteristics of ECM

Characteristics of Developing Countries

:  1995 Annual per capita GDP less than $8,995  85% of wold population  20% of world GDP  11% of world Stock Market Capitalization

Relative Size of Emerging Capital Markets (ECM):

 1985 $167.7B

 1995 $1.9T

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Characteristics of ECM

During the same time period, the growth in developed countries

:  1985 $4.5 T  1995 $15.9T

Investors are attracted to ECM because of:

 Return potentials  Diversification potentials

Performance of ECM:

 ECM are characterized by high risk, high return and diversification benefits.

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Gains from International Diversification

Gains from International Diversification.

 Rationale: international equity market has higher E(R) than the US market and can substantially diversify US portfolio.

 Asset pricing models do not argue that risk factors have geographically different E(R).

 In the US market, value and size explain the difference in E(R) across equity portfolio  International value stocks and small stocks diversify US portfolio more than EAFE. 11

Gains from International Diversification

Performance of International Open-end Funds  Standard Deviation of Monthly Returns;  Sharpe Ratio for International Funds;  Jensen’s Alpha for International Funds.

Analyze performance of Well-Diversified Funds.

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Conclusions

Conclusions:

 ECMs are an asset class of growing importance  Historical performance is inconsistent with common assertion that ECMs always produce higher average returns.

 ECMs offers diversification opportunities to global investors.

 Optimal asset allocation changes from period to period.

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Conclusions

Future studies should examine:

 Economic reforms and performance of ECMs  Concentration of wealth in the hands of a small number of families/holding companies.

 Advantages and disadvantages of these organizational structure?.

 Corporate financial policies of firms and their effects on market valuation.

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