International Portfolio Investment

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International Portfolio Investment
11Chapter Ten

• Chapter Objective
• This chapter discusses the gains from
  international portfolio diversification, which
  emerged as a major form of cross-border
  investment in the 1980s, rivaling foreign direct
  investment by firms.
• Chapter Outline
• Portfolio Arithmetic International Perspectives
  
• Optimal International Portfolio Selection
• International Mutual Funds A Performance
  Evaluation
• International Diversification through Country
  Funds
• International Diversification with ADRs
• International Diversification with WEBS
• International Diversification with Hedge Funds
• Why Home Bias in Portfolio Holdings

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Portfolio Arithmetic International Perspectives

• Investment in international securities offer
  opportunities for diversification but increases
  foreign exchange risk
• For example,
• A Canadian portfolio manager buys 10 UK shares at
  10 per share, at 2.30/
• At the end of the period, the shares have risen
  in value to 110, but the pound falls to 2.10/
  The transactions are summarized

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Portfolio Arithmetic International
Perspectives

• Three rates of return

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Portfolio Arithmetic International
Perspectives
C gain or loss on British Investment End of
Period
Conditional Exchange rates /
Conditional Share values,
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International Portfolio Diversification
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Optimal International Portfolio Selection

• Security returns are much less correlated across
  countries than within a country.
• This is so because economic, political,
  institutional, and even psychological factors
  affecting security returns tend to vary across
  countries, resulting in low correlations among
  international securities.
• Business cycles are often high asynchronous
  across countries.
• The correlation of Canadian stock markets with
  the returns on the stock markets in other nations
  varies.
• The correlation of the U.S. market with the
  Canadian market is in the 0.60 to 0.75 range.
• The correlation of the U.S. market with the
  Japanese market is 0.24.
• A U.S. investor would get more diversification
  from investments in Japan than Canada.

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Canadian Dollar-Based Equity Market Returns
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Summary Statistics of Returns of 11 Major Stock
Market Indices
Relatively low international correlations imply
that investors should be able to reduce portfolio
risk more if they diversify internationally
rather than domestically.

• measures the sensitivity of the market to the
  world market.
• Clearly the Japanese market is more
  sensitive to the world market than is the U.S.

(1996-2007, weekly data, annualized)
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Domestic versus International Diversification
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International Portfolio DesignThe simple case of
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International Portfolio DesignThe simple case of
2
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The Optimal International Portfolio
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The Optimal International Portfolio
The optimal proportion of investment in foreign
assets in any particular country is greater 1.
The greater is the expected return on foreign
assets (recorded in terms of foreign currency)
relative to expected returns on domestic
assets. 2. The greater is the expected (real)
appreciation of foreign currency against the
investors home currency. 3. The lower is the
risk (standard deviation) of returns on foreign
assets (converted to the domestic investors
currency) compared to the risk of domestic
investment. 4. The smaller is the correlation
coefficient between returns on foreign assets
(converted to the domestic investors currency)
and returns on domestic assets. 5. The lower is
the domestic risk-free rate.
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11.3 International Mutual Funds Access to the
World

• A Canadian investor can easily achieve
  international diversification by investing in a
  Canadian-based international mutual fund.
• The advantages include
• Savings on transaction and information costs.
• Circumvention of legal and institutional barriers
  to direct portfolio investments abroad.
• Professional management and record keeping.

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International Mutual Funds A Performance
Evaluation
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11.4 International Diversification through
Country Funds

• Recently, country funds have emerged as one of
  the most popular means of international
  investment.
• A country fund invests exclusively in the stocks
  of a single county. This allows investors to
• Speculate in a single foreign market with minimum
  cost.
• Construct their own personal international
  portfolios.
• Diversify into emerging markets that are
  otherwise practically inaccessible.

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US and Home Market Betas of Country Funds and
their Net Asset Values (1985-91)
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11.5 International Diversification with American
Depository Receipts (ADRs)

• It is a receipt that represents the number of
  foreign shares that are deposited at a U.S. bank.
  The bank serves as a transfer agent for the ADRs
• There are many advantages to trading ADRs as
  opposed to direct investment in the companys
  shares
• ADRs are denominated in U.S. dollars, trade on
  U.S. exchanges and can be bought through any
  broker.
• Dividends are paid in U.S. dollars.
• Most underlying stocks are bearer securities, the
  ADRs are registered.
• Adding ADRs to domestic portfolios has a
  substantial risk reduction benefit.

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11.6 International Diversification with World
Equity Benchmark Shares

• World Equity Benchmark Shares (WEBS)
• Country-specific baskets of stocks designed to
  replicate the country indexes of 20 countries.
• WEBS are subject to U.S. SEC and IRS
  diversification requirements.
• Low cost, convenient way for investors to hold
  diversified investments in several different
  countries.
• Recent research suggests that WEBs are an
  excellent tool for international risk
  diversification.
• For investors who desire international exposure,
  WEBs may well serve as a major alternative to
  such traditional tools as international mutual
  funds, ADRs, and closed-end country funds

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11.7 International Diversification with Hedge
Funds

• Unlike traditional mutual funds that depend on
  buy and hold strategies, hedge funds may adopt
  flexible, dynamic strategies, often aggressively
  using leverage, short positions and derivative
  contracts.
• Usually not subject to reporting and disclosure
  requirements.
• They allow investors to increase international
  diversification because
• They tend to have low correlation with stock
  market indices
• Allow investors access to foreign markets that
  are sometimes not easily accessible.

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The Home Bias in Equity Portfolios

• Home bias refers to the extent to which portfolio
  investments are concentrated in domestic equities.

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Why Home Bias in Portfolio Holdings?

• Three explanations come to mind
• Domestic equities may provide a superior
  inflation hedge.
• Home bias may reflect institutional and legal
  restrictions on foreign investment.
• Extra taxes and transactions/information costs
  for foreign securities may give rise to home bias.

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Summary

• International portfolio investment has be growing
  recently because of deregulation and new
  investment instruments
• Diversification reduces risk Lower covariance
  across countries (than within countries) means
  international diversification reduces risk more
• More effective diversification means higher
  returns for a fixed level of risk
• Foreign exchange uncertainty adds to the risk of
  foreign investments hedging of forex risks
  allows investors to enhance overall gains from
  international diversification
• Domestically-based mutual funds and closed-end
  country funds allow investors to achieve
  international diversification at home. The
  majority outperform the domestic stock market in
  terms of the Sharpe performance measure
• Despite potential gains from international
  diversification investors allocate a
  disproportionate share of their assets to
  domestic securities. Home bias likely reflects
  imperfections in international markets.