1. Ephraim CLARK, www.countrymetrics.com e.clark@countrymetrics.com CONSTRUCTING AND TESTING THE “WORLD MARKET PORTFOLIO” FOR DOLLAR BASED INVESTORS Ephraim Clark Kostas Kassimatis

2. Ephraim CLARK, www.countrymetrics.com e.clark@countrymetrics.com SUMMARY 1 u The market portfolio is prominent in theoretical and practical asset pricing u The true market portfolio cannot be observed directly u WE ARGUE: It can be constructed from macro- economic cash flow data u INTUITION: “market portfolio is the value of the economy u

3. Ephraim CLARK, www.countrymetrics.com e.clark@countrymetrics.com SUMMARY 2 u We construct this proxy that we call the “world market portfolio” u We test it over the period 1974-2003 u IMPORTANT: this portfolio includes all assets including human capital u IMPORTANT: this portfolio differs from other proxy portfolios in that it is not a simple summation of prices of individual assets and thus the tests do not suffer from the tautology problem.

4. Ephraim CLARK, www.countrymetrics.com e.clark@countrymetrics.com SUMMARY 4 u The portfolio is efficient with respect to a broad asset universe that includes international money markets, medium and long term government bonds, stock market indices, commodities and real estate. u It has a statistically significant correlation across all the asset classes. u It is a powerful forecasting tool for constructing portfolios that outperform other popular portfolio proxies and benchmarks.

5. Ephraim CLARK, www.countrymetrics.com e.clark@countrymetrics.com

10. The Model

11. Ephraim CLARK, www.countrymetrics.com e.clark@countrymetrics.com DATA u Relevant quarterly macroeconomic and exchange rate data for 90 countries from Datastream over the period 1974-2003 and applied the procedures outlined above.

12. Ephraim CLARK, www.countrymetrics.com e.clark@countrymetrics.com WORLD MARKET PORTFOLIO Table 1 Summary statistics for quarterly returns of the World market portfolio u Mean return1.75% u St. Devn.3.36% u Kurtosis0.008 u Skewness0.20

13. Ephraim CLARK, www.countrymetrics.com e.clark@countrymetrics.com TESTING THE PORTFOLIO u Quarterly data for four types of assets: –stocks, government bonds, money markets and commodities. –1974 quarter 1 for most stocks, foreign exchange and some commodities, and –1985 quarter 2 for the remaining series. –ending 2003, quarter 4 for all series. –all data are available on Datastream. –returns for all assets are in U.S. dollars and excess returns are computed using the 3 month U.S. T-bill rate.

14. Ephraim CLARK, www.countrymetrics.com e.clark@countrymetrics.com STOCKS u 19 countries: Australia, Austria, Belgium, Canada, Denmark, France, Germany, Hong Kong, Ireland, Italy, Japan, Netherlands, Norway, Singapore, South Africa, Sweden, Switzerland, U.K. and U.S.

15. Ephraim CLARK, www.countrymetrics.com e.clark@countrymetrics.com BONDS u 20 total return series: – 10 year benchmark government bonds for Germany, Canada, France, Ireland, Japan, Austria, Switzerland, U.K. and U.S. – 5 year benchmark government bond for Germany, Belgium, Canada, Denmark, France, Ireland, Japan, Austria, Sweden, Switzerland and U.K., a total of 20 series.

16. Ephraim CLARK, www.countrymetrics.com e.clark@countrymetrics.com MONEY MARKET 11 series: Australia, Belgium, Canada, Denmark, France, Germany, Italy, Japan, Netherlands, Switzerland and U.K.

17. Ephraim CLARK, www.countrymetrics.com e.clark@countrymetrics.com COMMODITIES u total returns for five indices: Livestock, Precious Metals, Energy, Industrial Metals and Real Estate –Goldman Sachs total return for first 4 –The real estate index (NAREIT) is compiled by the National Association of Real Estate Investment Trusts (only US available)

18. Ephraim CLARK, www.countrymetrics.com e.clark@countrymetrics.com EFFICIENCY TESTS u Regress excess return = a +br u Gibbons et al (1989) multivariate test for the joint significance of the intercepts in the equation u 1974Q1-2003: 28 series u 1985Q2-2003: all 55 series

19. Ephraim CLARK, www.countrymetrics.com e.clark@countrymetrics.com Results on efficiency tests u 1974 Q1 – 2003 Q4 –Stocks: 0.734 (0.77) –Stocks & Comm: 0.677 (0.85) –Stocks & MM & Comm:0.809 (0.73)

20. Ephraim CLARK, www.countrymetrics.com e.clark@countrymetrics.com Results on efficiency tests u 1985 Q2 – 2003 Q4 –Stocks1.155 (0.33) –Bonds0.750 (0.76) –MM1.504 (0.15) –Stocks & MM & Comm.1.076 (0.41) –Stocks & Bonds & Comm.0.683 (0.88) –Bonds & MM & Comm.1.273 (0.23) –MM & Comm. 1.510 (0.12) –All assets1.369 (0.21)

21. Ephraim CLARK, www.countrymetrics.com e.clark@countrymetrics.com Testing for Relevance in Returns and Risk Reduction u Betas for assets estimated with the world market portfolio –Stocks: significant for 13 out of 19 markets, 8 at the 1% level, 4 at the 5% level and 1 at the 10% level. –Money markets: 10 betas are significant at the 1% level, while the beta for Canada is significant at the 10% level. –Bonds: all betas are statistically significant, three at the 5% level and 17 at the 1% level. –Commodities: two of the 5 betas are significant. –Importantly, very few alphas are significant at conventional levels: eleven for stocks, one for the money market, four for bonds and one for commodities.

22. Ephraim CLARK, www.countrymetrics.com e.clark@countrymetrics.com OUT OF SAMPLE TESTING u Ex ante portfolio construction u Two portfolios: –one for which we have prices from 1974Q1 to 2003 Q4 –one for which we consider all assets in our sample from 1985Q2 to 2003Q4. –the optimization is based on betas which are estimated using the previous 10 years of quarterly observations.

23. Ephraim CLARK, www.countrymetrics.com e.clark@countrymetrics.com Table 6. Portfolio performance World Market PortfolioMSCI Mean St. Devn. Sharpe Mean St. Devn. Sharpe 1. 1984Q1 – 2003Q4 2.66 6.44 20.98 2.16 4.97 17.23 1. 1995Q2 – 2003Q4 2.268.11 15.27 1.38 5.44 6.61 2. 1995Q2 – 2003Q4 2.15 6.60 17.04 1.29 3.77 6.96 Global MSCI 1995Q2 – 2003 Q4 2.21 9.05 13.1

24. Ephraim CLARK, www.countrymetrics.com e.clark@countrymetrics.com

25. Cumulative Return 1995-2003 u Optimizing with the world market portfolio gives a cumulative excess return of 37% for the whole period, about 3.56% per annum. u Optimizing with the MSCI gives a cumulative excess return of 6.7%, about 0.72% per annum.

26. Ephraim CLARK, www.countrymetrics.com e.clark@countrymetrics.com

28. PortfolioProxyMean Return Mean Excess Return Standard Deviation Sharpe Ratio StocksWorld3,10%2,08%9,88%0,210 MSCI3,00%1,98%9,53%0,208 S&P12002,92%1,90%9,53%0,199 Equally Weighted2,59%1,57%9,79%0,160 Naïve2,92%1,89%9,84%0,192

29. Ephraim CLARK, www.countrymetrics.com e.clark@countrymetrics.com PortfolioProxyMean Return Mean Excess Return Standard Deviation Sharpe Ratio BondsWorld1,79%0,76%3,43%0,223 MSCI1,57%0,55%4,50%0,122 S&P12001,54%0,52%4,50%0,115 Equally Weighted1,14%0,12%3,82%0,030 Naïve1,78%0,75%4,81%0,157

30. Ephraim CLARK, www.countrymetrics.com e.clark@countrymetrics.com PortfolioProxyMean Return Mean Excess Return Standard Deviation Sharpe Ratio MMWorld1,23%0,20%2,76%0,073 MSCI0,85%-0,17%3,20%-0,053 S&P12000,85%-0,17%3,18%-0,054 Equally Weighted0,96%-0,06%2,97%-0,022 Naïve0,95%-0,08%4,02%-0,019

31. Ephraim CLARK, www.countrymetrics.com e.clark@countrymetrics.com PortfolioProxyMean Return Mean Excess Return Standard Deviation Sharpe Ratio CommoditiesWorld2,08%1,06%5,89%0,179 MSCI2,01%0,98%5,89%0,167 S&P12002,00%0,98%5,89%0,166 Equally Weighted2,12%1,10%5,85%0,188 Naïve1,85%0,83%5,43%0,153

32. Ephraim CLARK, www.countrymetrics.com e.clark@countrymetrics.com Summary u We construct and test a portfolio more compatible with the “market portfolio” of financial theory u Motivation: a superior portfolio will be more effective for empirical testing of financial data and for international investing. u Intuition: the “market portfolio” of financial theory represents the total value of a national economy u Rather than adding up values of individual assets to determine a proxy for the national “market portfolio”, we use the Hicks (1987) model of discounted macro-economic cash flows to calculate the value of the economy directly u Avoid shortcomings of the popular proxy indices currently in use that generally exclude many asset classes and are vulnerable to the tautology weakness u All assets are represented in the country “market portfolios” but no individual assets enter the portfolio directly, we also avoid the tautology weakness. u Our international market portfolio proxy, which we call the world market portfolio, is calculated as the sum of the ninety national market portfolios in our sample.

33. Ephraim CLARK, www.countrymetrics.com e.clark@countrymetrics.com Conclusions u Tests of this portfolio for its potential empirical relevance for model testing and portfolio building u The portfolio is efficient with respect to a broad asset universe that includes international money markets, medium and long term government bonds, stock market indices, commodities and real estate u It has a statistically significant correlation across all the asset classes u It is a powerful forecasting tool for constructing portfolios that outperform other popular portfolio proxies and benchmarks.