1 Global Asset Allocation: The Case For International Investment Global Asset Allocation: The Case For International Investment Campbell R. Harvey, Ph.D., Professor, Duke University Global Asset Allocation and Stock Selection

2 The Plan International track record Returns and diversification Long horizon vs. short horizon What can we expect from U.S. equities? What to expect from international? Alternative views: dynamic strategies, hedge funds Research frontier – changing views of diversification Importance of GPR

3 One Year Treasury STRIP Two Year STRIP Five Year Treasury STRIP Seven Year Treasury STRIP Ten Year Treasury STRIP Twenty Year Treasury STRIP Thirty Year Treasury STRIP MBS Credit Aggregate Government Three Year Treasury STRIP Wilshire Small Cap Wilshire 5000 Wilshire Large Cap Wilshire Mid Cap EAFE X-Japan U.S. Investments Versus Non-U.S. Equities The International Track Record Source: Erb and Harvey (2002) EAFE

4 Returns and Diversification Data from MSCI

5 Returns and Diversification Data from IFC

6 Returns and Diversification Data from MSCI

7 Returns and Diversification Data from MSCI

8 Returns and Diversification Data from MSCI

9 Returns and Diversification Data from MSCI

10 Returns and Diversification Data from IFC

11 Returns and Diversification Data from IFC and MSCI

12 The Long Horizon Data from Dimson, Marsh and Stauton (2002)

13 The Long Horizon Data from Dimson, Marsh and Stauton (2002)

14 The Long Horizon Data from Dimson, Marsh and Stauton (2002)

15 The Long Horizon Data from Dimson, Marsh and Stauton (2002)

16 What to Expect Data from Dimson, Marsh and Stauton (2002)

17 What to Expect Source: Goldman Sachs (2002)

18 What to Expect Ten-year risk premium around 3.5% and stable whereas one-year risk premium quite variable 10-year premium1-year premium Source: Graham and Harvey (2002)

19 What to Expect U.S. Equity and Bond Returns are Positively Correlated Source: Erb and Harvey (2002)

20 What to Expect World Real Equity and Real Bond Returns are Positively Correlated Source: Erb and Harvey (2002)

21 What to Expect Inflation Negatively Related to Real Bill Returns Source: Erb and Harvey (2002)

22 What to Expect Inflation Negatively Related to Real Intermediate Bond Returns Source: Erb and Harvey (2002)

23 What to Expect Inflation Negatively Related to Real Bond Returns Source: Erb and Harvey (2002)

24 What to Expect Inflation Negatively Related to Real Equity Returns Source: Erb and Harvey (2002)

25 What to Expect Inflation Negatively Related to Real International Bill Returns Source: Erb and Harvey (2002)

26 What to Expect Inflation Negatively Related to Real International Bill Returns Source: Erb and Harvey (2002)

27 What to Expect Inflation Negatively Related to Real International Equity Returns Source: Erb and Harvey (2002)

28 What to Expect Inflation Negatively Related to Real International Equity Returns Source: Erb and Harvey (2002)

29 Alternative Vehicles Alternate Asset Classes Often Involve Implicit or Explicit Options Source: Naik (2002)

30 Alternative Vehicles Alternate Asset Classes Often Involve Implicit or Explicit Options Source: Naik (2002)

31 Alternative Vehicles Alternate Asset Classes Often Involve Implicit or Explicit Options Source: Naik (2002)

32 Alternative Vehicles Alternate Asset Classes Often Involve Implicit or Explicit Options Source: Naik (2002)

33 Alternative Vehicles Alternate Asset Classes Often Involve Implicit or Explicit Options Source: Figure 5 from Mitchell & Pulvino (2000)

34 Alternative Vehicles Alternate Asset Classes Often Involve Implicit or Explicit Options Russell 3000 Index Returns Event Driven Index Returns LOWESS fit Source: Naik (2002)

35 Rethinking Risk Traditional models maximize expected returns for some level of volatility Is volatility a complete measure of risk?

36 Rethinking Risk Much interest in downside risk, asymmetric volatility, semi-variance, extreme value analysis, regime-switching, jump processes,...

37 Rethinking Risk... These are just terms that describe the skewness in returns distributions. Most asset allocation work operates in two dimensions: mean and variance -- but skew is important for investors. Examples:

38 Rethinking Risk 1. The $1 lottery ticket. The expected value is $0.45 (hence a -55%) expected return. –Why is price so high? –Lottery delivers positive skew, people like positive skew and are willing to pay a premium

39 Rethinking Risk 2. High implied vol in out of the money OEX put options. –Why is price so high? –Option limits downside (reduces negative skew). –Investors are willing to pay a premium for assets that reduce negative skew

40 Rethinking Risk 3. Some stocks that trade with seemingly “too high” P/E multiples –Why is price so high? –Enormous upside potential (some of which is not well understood) –Investors are willing to pay a premium for assets that produce positive skew –[Note: Expected returns could be small or negative!]

41 Rethinking Risk Source: Harvey and Siddique (2000)

42 Rethinking Risk Data from MSCI

43 Rethinking Risk Data from IFC

44 U.S. Has Become a Riskier Global Investment The U.S. has become much more risky –High sensitivity to some GPRs –Disagreement on strength of economy –Financial information less credible These factors suggest shifting exposures from equity to safer fixed income

45 U.S. Has Become a Riskier Global Investment ICRG Political Risk Data from PRS

46 U.S. Has Become a Riskier Global Investment ICRG Political Risk Data from PRS

47 U.S. Has Become a Riskier Global Investment ICRG Political Risk Data from PRS

48 U.S. Has Become a Riskier Global Investment Risk Ratings December 2002 Data from PRS

49 U.S. Has Become a Riskier Global Investment Risk Ratings May 2001 Data from PRS

50 U.S. Has Become a Riskier Global Investment Higher risk means equity investors require a higher rate of return Risk Ratings from Institutional Investor

51 Equation implies an increase in the medium-term risk premium of 240bp –This helps explain the recent decline in the equity market –This helps explain the recent behavior of the U.S. dollar –This helps explain the slow down in real investment (hurdle rates are up) U.S. Has Become a Riskier Global Investment

52 International investment is mainly about returns – diversification, while important, is often “oversold” Expected returns depend on fundamental values today – not just historical return performance. U.S. risk has increased suggesting a reallocation from equity to fixed income Conclusions

53 All articles on –The Drivers of Expected Returns in International Markets (2000) –Global Tactical Asset Allocation (2001) with Magnus Dahlquist –The Term Structure of Equity Risk Premia (2002) with Claude Erb Readings