Bridge over ocean
1 March 2016 CFA Institute Journal Review

International Diversification: The Weighting Is the Hardest Part (Digest Summary)

  1. Neeti Goyal

Increasing international trade is leading to more correlation among the markets in developed countries. The authors propose a different international asset allocation strategy that reduces the impact of correlation among developed markets by including more developing markets.

What’s Inside?

Economic interdependence and increasing trade flow have made developed countries so much more correlated with each other that the benefits of portfolio diversification have been reduced. Weighting countries based on their GDP in an international portfolio of developed countries is not generating enough returns. The traditional asset allocation strategy of combining different types of financial products is also not generating the desired returns. The authors propose a trade-adjusted portfolio-weighting approach that limits the integration effects on the diversified portfolio.

How Is This Research Useful to Practitioners?

The fundamental reason behind diversification is that by diversifying across a larger number of securities, the idiosyncratic risk of any particular security is reduced. In the past when returns started to decline on securities, investors would turn to bonds. But with current yields so low in developed markets, the income protection from bonds is now negligible. Also, investors seem to have forgotten the golden rule of investing, which is to never lose money.

Economies are becoming more closely linked, and the correlation between countries and different types of financial products is increasing. Despite the recent growth in global financial flows, direct trade is the most important determinant of how movements in the world’s largest markets affect financial markets around the globe. The trade intensity measure the authors use indicates a strong, direct link between market correlation and international trade. They create trade-based portfolio weights to offset the impact of the correlation between markets. The resulting statistics from an equally weighted portfolio are similar to a trade-adjusted portfolio. But the Sharpe ratio of trade-adjusted weighting clearly indicates that investing in developing countries is beneficial. The authors’ work is insightful not only for portfolio managers but also for all investors.

How Did the Authors Conduct This Research?

The sample the authors use is gathered from the MSCI Total Return Index and broken into two datasets. One includes return data for 22 countries from 1989 to 2010, and the other includes return data for 44 countries from 1999 to 2010. The authors then compute the geometric return, standard deviation, Sortino ratio, and Sharpe ratio for each country in each set. They estimate a trade intensity measure that uses data on imports, exports, and GDP of a country compared with each other country.

A regression of the trade intensity measure against each country’s market correlation gives the relationship between any two country pairs. Returns and standard deviations are estimated for each country based on the portfolio weighting of each country in three ways: equally weighted, GDP weighted, and trade intensity weighted. The Sharpe ratio and the Sortino ratio of the trade-adjusted portfolio are superior to those of the GDP portfolio. Another measure used to substantiate the results is turnover ratio because it considers trading costs associated with buy and sell decisions.

Abstractor’s Viewpoint

“Be diversified” is the most overused phrase when it comes to investing. The problem these days is how to diversify. In the past, being diversified was a matter of choosing between shares and bonds with some cash on the side for a rainy day. Today, it is not that easy. The financial crisis revealed that most portfolios were not as diversified as investors thought. The theory behind diversification is that it spreads the risk around. So, investors have to decide how to diversify their risk and this research is a step in that decision-making process.

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