International Diversification CHAPTER 25 International Diversification

Background The U.S. accounts for only about a third of world stock market capitalization. Emerging markets make up about 16% of the world stock market. Of the six largest countries – U.S., Japan, U.K., France, Hong Kong and Canada – make up about 62% of the world stock market. The weight of the U.S. within this group of six is 54%. 2

Background Clearly, U.S. stocks do not comprise a fully diversified equity portfolio. International investing provides greater diversification opportunities. It also carries some special risks.

Figure 25.1 Per Capita GDP and Market Capitalization as Percentage of GDP

Issues A developed stock market enriches the population. Home-country bias: Investors frequently overweight home-country stocks. They may even completely ignore opportunities for international diversification.

Risk Factors in International Investing Foreign Exchange Risk Variation in return due to changes in the exchange rate. Foreign investments may yield more or less home currency than expected. A foreign investment is simultaneously an investment in an overseas asset and in a foreign currency. 6

Risk Factors in International Investing Two sources of variation or risk: Return expressed in local currency Return obtained when local currency is exchanged for home currency. 7 7

Example 25.1 Exchange Rate Risk Suppose the risk-free rate in U.K. is 10% and the current exchange rate is $2/£1. A U.S. investor with $20,000 can buy £10,000 and invest them to obtain £11,000 in one year. If the £ depreciates to $1.80, the investment will yield only $19, 800, a $200 loss. The investment was not risk free to a U.S. investor! 8

Example 25.1 Exchange Rate Risk The equation shows that the return to the U.S. investor is: The pound-denominated return Multiplied by The exchange rate “return” 9

Figure 25. 2 Stock Market Returns in U. S Figure 25.2 Stock Market Returns in U.S. Dollars and Local Currencies for 2009

Hedging Exchange Rate Risk Futures or forward markets are used to hedge the risk. The U.S. investor can make a riskless dollar return either by investing in UK bills and hedging exchange rate risk or by investing in riskless U.S. assets.

Political Risk In principle, security analysis at the macroeconomic, industry, and firm-specific level is similar in all countries. In practice, getting good information about foreign investments can be more difficult. PRS Group (Political Risk Services) assesses political risk by country. 12

Table 25.5 Variables used in PRS’s Political Risk Score

Table 25.6 Current Risk Ratings and Composite Risk Forecasts

Table 25.7 Composite and Political Risk Forecasts

Table 25.7 Interpretation The table captures country risk through scenario analysis. Risk stability is based on the difference in the rating between the best- and worst-case scenarios.

Table 25.8 Political Risk Points by Component

Foreign Investment Avenues Purchase securities directly in the capital markets of other countries. American depository receipts (ADR) International mutual funds International ETFs

Are Investments in Emerging Markets Riskier? For the overall portfolio, standard deviation of excess returns is the appropriate measure of risk. For an asset to be added to the current portfolio, beta (covariance with U.S. portfolio) is the appropriate measure of risk.

Figure 25.3 Monthly Std Deviation of Excess Returns in Developed, Emerging Markets

Figure 25.4 Index Dollar Return Beta on U.S. Stocks, 2000–2009

Figure 25.5 Average Dollar-Denominated Excess Returns

Average Country-Index Returns and Capital Asset Pricing Theory Figure 25.5 shows a clear advantage to investing in emerging markets. Results are consistent with risk ranking by standard deviation, but not with ranking by beta. Beta rankings may fail because of home-country bias, which dominates international investing.

Benefits from International Diversification Correlations between countries suggest international diversification is beneficial, especially for active investors. Globalization may have caused higher cross-country correlations. It’s possible to expand the efficient frontier some. It’s possible to reduce the systematic risk level below the domestic only level.

Figure 25.6 International Diversification

Figure 25.8 Efficient Frontier of Country Portfolios

Are Benefits Preserved in Bear Markets? Correlations between countries may increase in a crisis. Roll’s model suggests a common factor underlying the movement of stocks around the world. Prediction: Diversification only protects against country-specific events. What happened in 1987? In 2008?

Figure 25.9 Regional Indexes around the Crash, October 14–October 26, 1987

Figure 25.10 Beta and SD of Portfolios

Three Rules of Thumb To passively diversify your portfolio, include country indexes in order of: Market capitalization (from high to low) Beta against the U.S. (from low to high) Country index standard deviation (from high to low)

Figure 25.11 Risks and rewards of international portfolios, 2000–2009

Performance Attribution The EAFE index is a commonly used benchmark for portfolio performance. Measure the contribution of: Currency selection Country selection Stock selection Cash/bond selection

Table 25.15 Example of Performance Attribution: International