Transcript International portfolio diversification benefits: Cross

International portfolio
diversification benefits:
Cross-country evidence from a local perspective
By J. Driessen and L. Laeven
Presented by Michal Kolář, Tomáš Matuška,
Tomáš Šembera & Tomáš Václavíček
Presentation overview
I. Introduction and motivation of the topic
II. Data and research method
III. Empirical results – International diversification benefits
IV. Empirical results – Cross-country variation
V. Empirical results – Time- varying diversification benefits
VI. Conclusions and key points to remember
I. Introduction and motivation of the topic
How it relates to you personally
• Do you invest?
• And do you invest abroad?
• If not, you might be missing the benefits of diversification.
Research question
• Are there benefits to investing internationally for non-US investors?
• What is the economic size of diversification benefits?
• How do they differ by country – and based on what factors?
Why this hypothesis
• Many institutions required to invest domestically
• Home bias
• Regulations are being lifted
• Boom in international investing
• Essentially all literature focuses on US investors only
• Results not representative!
• How about investors in Czech Republic or elsewhere?
• Investing abroad can become more important if domestic market is small, restricted,…
II. Data and research method
What data were used
• 52 countries (29 developing, 23 rich)
• Monthly data on returns
• Time period: 1985 – 2002
• Some countries do not have that old data
• But provided consistently
How to measure it?
• Utility gain, when restriction is lifted
• Adding a set of assets to benchmark set (K = 1)
I. Improvement in Expected returns
II. Increase in Sharpe ratio
• Sharpe ratio = measure of risk-adjusted return
Benefits of investing regionally
Benefits of investing globally
Comparison
• Investing in domestic stock
market
• Investing domestically + into
regional stock market
Comparison
• Investing in domestic stock
market
• Investing domestically + into
global stock market
• MSCI indices for the US,
Europe, and Far East
A) No market frictions
3 possible
assumptions
• Short sales constraints
B) Frictions in developing countries
C) Frictions in all countries
III. Empirical results - International
diversification benefits
Regional diversification
• Largest benefits from diversification in Eastern Europe
• No benefits from diversification when short selling constraint are present
(except for Eastern Europe)
Global diversification
• No friction: Increase of Shape Ration from 1,3 % to 46,3 % expressed in
local currency, from 1,5 % to 27,1 % expressed in US $ ( -> 11 % increase
on average in US$)
• Short-selling constraints in developing countries -> don’t affect results
• Short-selling constraints in all countries -> unrealistic; substantial
decrease of benefits of diversification
IV. Empirical results - Cross-country variation
What causes the variation in benefits?
• Dependent variable
 Increase in Sharpe ratio
• SR of the Global portfolio – SR of the local portfolio
• Independent variables
 ICRG country risk rating
• Proxy for the country risk
(The higher rating the less country risk)
• Proxy for the investment restrictions, political risk, investor protection and foreign exchange
regulations
What does cause variation in benefits?
• Independent variables
 Market capitalization of stock market
• Proxy size of the stock market
 Trade openess
• Proxy integration in world goods markets
 Private credit to GDP
• Proxy financial sector development in country
Cross-country regression results
• Only ICRG rating significant
• Doubts about causality
 Using IV -> Instrument Legal Origin
• Quality of the institutional framework
• Qualitatively same results
Cross-country regression results
• Country risk is major determinant of GD Benefits
• Benefits much larger for countries with higher risk
V. Empirical results - Time-varying
diversification benefits
Why analysing time variation
• Further confirmation of country risk – diversification benefits relationship in
time -> If country risk decreases, the diversification benefits should decrease
too
Measuring determinants of diversification
benefits
• 1) Moments of returns of local indices estimated using ICRG composite risk
index
• Expected return
• Volatility
• Correlation with regional or global index
Expected returns
• Decrease of returns in time should increase the diversification benefits
• 𝐸𝑡 𝑅𝑖,𝑡+1 = ∝𝑖 + 𝛽𝑖 𝐼𝐶𝑅𝐺𝑖,𝑡
• Translated into regression equation:
• 𝑅𝑖, 𝑡+1 = ∝𝑖 + 𝛽𝑖 𝐼𝐶𝑅𝐺𝑖,𝑡 + 𝜀𝑖, 𝑡+1
Volatility of returns
• Decrease in volatility should decrease the benefits of diversification
• 𝑉𝑡 𝑅𝑖, 𝑡+1 = exp(𝛾𝑖 + 𝛿𝑖 𝐼𝐶𝑅𝐺𝑖,𝑡 )
• Translated into:
• 𝜀 2 𝑖,𝑡+1 = exp 𝛾𝑖 + 𝛿𝑖 𝐼𝐶𝑅𝐺𝑖,𝑡+1 + 𝜀 ∗ 𝑖,𝑡+1
Correlation with indices
• Increase in correlation should decrease diversification benefits
• 𝜌𝑡 𝑅𝑖,𝑡+1 , 𝑅𝑗,𝑡+1 = 2Φ 𝜉𝑖,𝑗 + 𝜂𝑖,𝑗 𝐼𝐶𝑅𝐺𝑖,𝑡 − 1
• Translated into:
•
𝜀𝑖,𝑡+1 𝜀𝑗,𝑡+1
exp( 𝛾𝑖 + 𝛿𝑖 𝐼𝐶𝑅𝐺𝑖,𝑡 𝛾𝑗 + 𝛿𝑗 𝐼𝐶𝑅𝐺𝑗,𝑡 )
= 2Φ 𝜉𝑖,𝑗 + 𝜂𝑖,𝑗 𝐼𝐶𝑅𝐺𝑖,𝑡 − 1 + 𝜀 ∗∗ 𝑖𝑗,𝑡+1
Results
• For 42 out of 52 countries (period 1985 – 2002) the increase in ICRG
caused:
• Increase in correlation with regional or global indices
• Decrease in expected returns
• Decrease in volatility of returns
• The effect of country risk measure on diversification benefits is not clear
Finding the effect on diversification benefits
• Equations of returns, volatility and correlation used to compute the Sharpe
ratios
• Decrease in diversification benefits over time (decrease in volatility and increase in
correlation outweighed the decrease in expected returns)
• The decrease significant for region with developing countries
• No clear pattern in change of diversification benefits for developed countries
Conclusions and key points to remember
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There are substantial regional and global benefits from diversification
More significant effect for developing countries
Diversification benefits decreased in the period 1985 – 2002
The decrease corresponds to decrease of country risk:  CR   benefits
Contribution of paper is focusing on investors outside USA
Thank you for your attention