Title: The Case for Constructing Global Investment Portfolios
1The 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
2Relative 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
3Global Bond Portfolio Risk
- Macroeconomic differences cause the correlation
of bond returns between the United States and
foreign countries to differ - The correlation of returns between a single pair
of countries changes over time because the
factors influencing the correlation change over
time
4Risk 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
5Summary 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
6Global 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
7International 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
8International 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
9International 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
10Equity Investments
- Returns are not contractual and may be better or
worse than on a bond
11Equity Investments
- Common Stock
- Represents ownership of a firm
- Investors return tied to performance of the
company and may result in loss or gain
12Classification 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
13Acquiring 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
14American 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
15Purchase or Sale of American shares
- Issued in the United States by transfer agent on
behalf of a foreign firm - Higher expenses
- Limited availability
16Direct 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
17Purchase 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
18Special 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
19Futures 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
20Financial 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
21Investment 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
22Investment 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
23Investment 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
24Investment 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
25Investment 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
26Investment 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
27Real 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
28Direct 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
29Direct 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
30Direct 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
31Direct 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
32Real Assets
- Antiques
- Art
- Coins and Stamps
- Diamonds
33Historical 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
34Reilly 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
35Real Estate
- Negative correlation between residential and farm
real estate and stocks - Low positive correlation between commercial real
estate and stocks - Potential for diversification