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 ofU.S. Financial Markets

• Overall value of the total investable capital
  market has increased from 2.3 Trillion in 1969
  to 70.9 Trillion in 2003 and the U.S. portion
  has declined to less than half.
• This trend is likely to continue

3
Global Bond Portfolio Risk

1. Macroeconomic differences cause the correlation
   of bond returns between the United States and
   foreign countries to differ
2. The correlation of returns between a single pair
   of countries changes over time because the
   factors influencing the correlation change over
   time

4
Risk of Combined Country Investments

• Diversified portfolios reduce variability of
  returns over time
• Correlation coefficients measure diversification
  contribution
• Compare correlation of return among U.S. bonds
  and stocks with returns on foreign bonds and
  stocks

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
Global Investment Choices

• Fixed-income investments
• bonds and preferred stocks
• International Bonds
• Equity investments
• Special equity instruments
• warrants and options
• Futures contracts
• Investment companies
• Real assets

7
International Bond Investing

• Investors should be aware that there is a very
  substantial fixed income market outside the
  United States that offers additional opportunity
  for diversification

8
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

9
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

10
Equity Investments

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

11
Equity Investments

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

12
Classification of Common Stock Categorized By
General Business Line

• Industrial manufacturers of automobiles,
  machinery, chemicals, beverages
• Utilities electrical power companies, gas
  suppliers, water industry
• Transportation airlines, truck lines, railroads
• Financial banks, savings and loans, credit unions

13
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

14
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

15
Purchase or Sale of American shares

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

16
Direct Purchase or Sale 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

17
Purchase or Sale of Global Mutual Funds or ETFs

• Global funds - invest in both U.S. and foreign
  stocks
• International funds - invest mostly outside the
  U.S.
• Funds can specialize
• Diversification across many countries
• Concentrate in a segment of the world
• Concentrate in a specific country
• Concentrate in types of markets
• Exchange-traded funds or ETFs are a recent
  innovation in the world of index products

18
Special Equity Instruments

• Equity-derivative securities have a claim on
  common stock of a firm
• Options are rights to buy or sell at a stated
  price for a period of time
• Warrants are options to buy from the company
• Puts are options to sell to an investor
• Calls are options to buy from a stockholder

19
Futures Contracts

• Exchange of a particular asset at a specified
  delivery date for a stated price paid at the time
  of delivery
• Deposit (10 margin) is made by buyer at contract
  to protect the seller
• Commodities trading is largely in futures
  contracts
• Current price depends on expectations

20
Financial Futures

• Recent development of contracts on financial
  instruments such as T-bills, Treasury bonds, and
  Eurobonds
• Traded mostly on Chicago Mercantile Exchange
  (CME) and Chicago Board of Trade (CBOT)
• Allow investors and portfolio managers to protect
  against volatile interest rates
• Currency futures allow protection against changes
  in exchange rates

21
Investment Companies

• Rather than buy individual securities directly
  from the issuer they can be acquired indirectly
  through shares in an investment company
• Investment companies sell shares in itself and
  uses proceeds to buy securities
• Investors own part of the portfolio of investments

22
Investment Companies

• Money market funds
• Acquire high-quality, short-term investments
• Yields are higher than normal bank CDs
• Typical minimum investment is 1,000
• No sales commission charges
• Withdrawal is by check with no penalty
• Investments usually are not insured

23
Investment Companies

• Bond funds
• Invest in long-term government, corporate, or
  municipal bonds
• Bond funds vary in bond quality selected for
  investment
• Expected returns vary with risk of bonds

24
Investment Companies

• Common stock funds
• Many different funds with varying stated
  investment objectives
• Aggressive growth, income, precious metals,
  international stocks
• Offer diversification to smaller investors
• Sector funds concentrate in an industry
• International funds invest outside the United
  States
• Global funds invest in the U.S. and other
  countries

25
Investment Companies

• Balanced funds
• Invest in a combination of stocks and bonds
  depending on their stated objectives
• Index Funds
• These are mutual funds created to equal the
  performance of a market index like the SP 500

26
Investment Companies

• Exchange-Traded Funds (ETFs)
• These are depository receipts for a portfolio of
  securities deposited at a financial institution
  in a unit trust that issues a certificate of
  ownership for the portfolio of stocks
• The stocks in a portfolio are those in an index
  like the SP 500 and dozens of country or
  industry indexes
• ETFs can be bought and sold continuously on an
  exchange like common stock

27
Real Estate Investment Trusts (REITs)

• Investment fund that invests in a variety of real
  estate properties
• Construction and development trusts provide
  builders with construction financing
• Mortgage trusts provide long-term financing for
  properties
• Equity trusts own various income-producing
  properties

28
Direct Real Estate Investment

• Purchase of a home
• Average cost of a single-family house exceeds
  100,000
• Financing by mortgage requires down payment
• Homeowner hopes to sell the house for cost plus a
  gain

29
Direct Real Estate Investment

• Purchase of raw land
• Intention of selling in future for a profit
• Ownership provides a negative cash flow due to
  mortgage payments, taxes, and property
  maintenance
• Risk from selling for an uncertain price and low
  liquidity

30
Direct Real Estate Investment

• Land Development
• Buy raw land
• Divide into individual lots
• Build houses or a shopping mall on it
• Requires capital, time, and expertise
• Returns from successful development can be
  significant

31
Direct Real Estate Investment

• Rental Property
• Acquire apartment buildings or houses with low
  down payments
• Derive enough income from the rents to pay the
  expenses of the structure, including the mortgage
  payments, and generate a good return
• Rental property provides a cash flow and an
  opportunity to profit from the sale of the
  property

32
Real Assets

• Antiques
• Art
• Coins and Stamps
• Diamonds

33
Historical Risk-Returns on Alternative Investments

• World Portfolio Performance
• Reilly and Wright (2004) examined the performance
  of various investment alternatives from the
  United States, Canada, Europe, Japan, and the
  emerging markets for the period 1980-2001

34
Reilly and Wrights 2004 Study

• Asset Returns and Total Risk
• Positive relationship between rates of return and
  total risk
• Return and Systematic Risk
• Beta explained the returns better than did the
  total risk measure
• Correlations between Asset Returns
• U.S. equities have high correlation with Canadian
  and U.K. stocks but low correlation with emerging
  market stocks and Japanese stocks
• U.S. equities have zero correlation with world
  government bonds, except U.S. bonds

35
Real Estate

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