In examining the relationship between US investors’ portfolio reallocations and returns, the authors find some evidence that portfolio shifts are related to past returns in the underlying equity markets. US investors may be exploiting mean reversion in underlying equity markets, rebalancing away from equity markets that recently performed well, and moving into equity markets just prior to expected relative strong performance.
The authors’ objective is to examine the mechanisms behind uncovered equity parity (UEP). Uncovered equity parity refers to a relationship between the expected performance of stock markets and currency levels. UEP portfolio rebalancing can include two distinct steps. First, when foreign equity holdings outperform domestic holdings, domestic investors are exposed to higher relative exchange rate exposure and may decide to repatriate some of the foreign equity to decrease exchange rate risk. Second, the associated selling of foreign currency leads to foreign currency depreciation. The authors argue that the first step of UEP does not occur because investors do not usually rebalance international equity portfolios away from countries whose markets have recently done well. Investors usually purchase equities from countries whose markets have recently performed well, as evidenced by common carry trade strategies.
How Is This Research Useful to Practitioners?
The authors analyze international positions in foreign-held, US-issued foreign currency debt as of June 2010 and the correlation between exchange rates and flows for 42 foreign countries for the period from 1990 to December 2010. They find statistically significant correlations between the log exchange rate returns and the change in net–net equity outflows (the change in outflows minus the change in inflows, scaled by the average change in flows) for such advanced economies as Austria and Switzerland and for such emerging market economies as Brazil, Malaysia, and South Africa. This evidence suggests that trading patterns in US investors’ foreign equity portfolios arise from a relationship between reallocations and returns of the underlying equity markets rather than from investors’ reaction to currency movements. That result, however, does not mean that investors do not react to currency exposure. Data limitations preclude an analysis of currency exposure.
The relationship between reallocations and past equity and currency returns for the same period of time in terms of total returns, currency returns, and equity returns is examined. The authors also study the relationship between reallocations and future portfolio returns in terms of total returns, currency returns, equity returns, and investor buy/sell timing measures. The evidence suggests a positive relationship between equity returns and portfolio adjustments, which could be the result of price pressure, and this finding is consistent with one aspect of UEP. Furthermore, they find that portfolio rebalancing is not the result of past currency movements but rather of movements in underlying equity markets.
How Did the Authors Conduct This Research?
For the empirical analysis, the authors use such international position information as US holdings of foreign equities, foreign currency–denominated debt securities, and outstanding US-issued foreign currency debt obtained from the US Treasury Department from June 2010 through 2011.
To analyze the correlation between exchange rates and flow, the authors obtain data for 42 foreign countries for the period from January 1990 to December 2010 for the euro area aggregate. During their empirical assessment of UEP, the authors examine the various legs of the UEP condition by studying the relationships between flows or portfolio reallocations and current, past, and future returns in the following three areas: flows and contemporaneous returns (an assessment of price pressure on exchange rates), past returns (an analysis of whether investors rebalance), and portfolio reallocations and future returns (an examination of whether investors are positioned to reduce exposure or to increase future returns).
Within the assessment of flows and contemporaneous returns, the authors use the Treasury International Capital (TIC) flow data scaled by the gross trading sum of purchases and sales and note that equity flows cause exchange rate movements.
Within the analysis of past returns, the authors use portfolio data to assess the existence of trading behavior. They use Bertaut and Tryon (FRB International Finance Discussion Paper 2007) estimates of the monthly bilateral positions of US investors in the equities of a large set of foreign countries. The Bertaut–Tryon data are formed by combining high-quality but infrequent readings on positions from security-level benchmark surveys with more frequent flow data. For each country in which the market (as represented by MSCI firm) is held, the authors are able to compute the unhedged dollar returns earned by US investors on their foreign equity portfolios.
For portfolio reallocations and future returns, the authors determine that the portfolio reallocations are tactical decisions to increase future returns. The equity return analysis shows positive and significant conditional weight-based measure coefficients for time horizons of one, two, and three months whereby US investors switched into equity markets that subsequently performed abnormally well compared with predicted returns.
The authors leverage prior research from notable publications and focus on UEP and rebalancing in international portfolios. The dataset includes monthly returns from 1990 to 2010 for 42 foreign markets as well as the respective US portfolio weights making up $4,161 billion of the $4,647 billion in US foreign equity holdings as of December 2010. The article is well organized and flows logically, with five tables of analysis that directly support the authors’ conclusions. The research should be of interest to practitioners and private investors who study international macroeconomic research on gross financial flows and international portfolio allocations.