The Case for Constructing Global Investment Portfolios

1
The Case for Constructing Global Investment
Portfolios

• Ignoring foreign markets can substantially reduce
  the investment choices for U.S. investors
• The rates of return on non-U.S. securities often
  have substantially exceeded those for U.S.-only
  securities
• The low correlation between U.S. stock markets
  and many foreign markets can help to
  substantially reduce portfolio risk

2
Relative Size of U.S. Financial Markets

• The share of the U.S. in world capital markets
  has dropped from about 65 percent of the total in
  1969 to about 48 percent in 2000
• The growing importance of foreign securities in
  world capital markets is likely to continue

3
The Case for Global Investments

• Rates of return available on non-U.S. securities
  often exceed U.S. Securities due to higher
  growth rates in foreign countries, especially the
  emerging markets

4
The Case for Global Investments

• Diversification with foreign securities can
• help reduce portfolio risk because foreign
• markets have low correlation with U.S. capital
• markets

5
Summary on Global Investing

• Relatively high rates of return combined with low
  correlation coefficients indicate that adding
  foreign stocks and bonds to a U.S. portfolio will
  reduce risk and may increase its average return

6
International Bond Investing

• Bond identification characteristics
• Country of origin
• Location of primary trading market
• Home country of the major buyers
• Currency of the security denomination
• Eurobond
• An international bond denominated in a currency
  not native to the country where it is issued

7
International Bond Investing

• Yankee bonds
• Sold in the United States and denominated is U.S.
  dollars, but issued by foreign corporations or
  governments
• Eliminates exchange risk to U.S. investors
• International domestic bonds
• Sold by issuer within its own country in that
  countrys currency

8
Equity Investments

• Returns are not contractual and may be better or
  worse than on a bond

9
Equity Investments

• Common Stock
• Represents ownership of a firm
• Investors return tied to performance of the
  company and may result in loss or gain

10
Acquiring Foreign Equities

• 1. Purchase of American Depository Receipts
  (ADRs)
• 2. Purchase of American shares
• 3. Direct purchase of foreign shares listed on a
  U.S. or foreign stock exchange
• 4. Purchase of international mutual funds

11
American Depository Receipts (ADRs)

• Easiest way to directly acquire foreign shares
• Certificates of ownership issued by a U.S. bank
  that represents indirect ownership of a certain
  number of shares of a specific foreign firm on
  deposit in a U.S. bank in the firms home country
• Buy and sell in U.S. dollars
• Dividends in U.S. dollars
• May represent multiple shares
• Listed on U.S. exchanges
• Very popular

12
Purchase or Sale of American shares

• Issued in the United States by transfer agent on
  behalf of a foreign firm
• Higher expenses
• Limited availability

13
Direct Purchase of Foreign Shares

• Direct investment in foreign equity markets-
  difficult and complicated due to administrative,
  information, taxation, and market efficiency
  problems
• Purchase foreign stocks listed on a U.S. exchange
  limited choice

14
Returns of Stocks, Bonds, and T-Bills

• Ibbotson and Sinquefield (IS) examined nominal
  and real rates of return for seven major classes
  of assets in the United States
• 1. Large-company common stocks
• 2. Small-capitalization common stocks
• 3. Long-term U.S. government bonds
• 4. Long-term corporate bonds
• 5. Intermediate-term U.S. Treasury bills
• 6. U.S. Treasury bills
• 7. Consumer goods (inflation)

15
Derived Series Historical Highlights (1926 -
2001)

• I S computed geometric and arithmetic mean
  rates of return
• They derived four return premiums
• 1. Risk premium
• 2. Small-stock premium
• 3. Horizon premium
• 4. Default premium

16
Annual Total Returns,1926-2001
Average Standard Return
Deviation Distribution Arith Geom
Small-company stocks 17.3 12.5
33.2 Large-companystocks 12.7
10.7 20.2 Long-termcorporate bonds 6.1
5.8 8.6 Long-termgovernment
5.7 5.3 9.4 Intermediate-termgovern
ment 5.5 5.3 5.7 U.S.
Treasurybills 3.9
3.8 3.2 Inflation 3.1
3.1 4.4
17
Returns of Stocks, Bonds, and T-Bills

• Returns and risk increase together
• Rates of return are generally consistent with the
  uncertainty of returns

18
The Effect of Taxes and Inflation on Investment
Returns, 1926 - 1998
Figure 2.6
Before Taxes
After Taxes and Inflation
After Taxes
19
World Portfolio Performance

• Ibbotson, Siegel, and Love examined the
  performance of assets around the world
• Asset return and risk relationship is confirmed
• Coefficients of variation range widely, showing
  benefits of global diversification
• Correlations between asset returns vary by global
  regions

20
Real Estate

• Returns are difficult to derive due to lack of
  consistent data
• Residential shows lower risk and return than
  commercial real estate
• During some short time periods REITs have shown
  higher returns than stock with lower risk
  measures
• Long term returns for real estate are lower than
  stocks, and have lower risk

21
Real Estate

• Negative correlation between residential and farm
  real estate and stocks
• Low positive correlation between commercial real
  estate and stocks
• Potential for diversification