UPDATE: Benefits of International Portfolio Diversification

Do findings currently indicate that co-movements among the U.S., Germany, and Japan markets are significant?

2012 Volume 15 Issue 2

In my 2007 article (Vol. 10, Issue 2) I studied the issue of risk reduction through international diversification. Using data from the U.S., Germany, and Japan during 1999 to 2002, the analyses supported the findings of the existing literature that the co-movements among the U.S. and German stock markets were significant. The Japanese stock market, on the other hand, had almost no significant effect on the movement of the other markets. The implication was that both German and Japanese investors should consider investing in each other’s markets for effective portfolio diversification while American investors can realize diversification benefits in Japan. However, diversification benefits are minimal for American and German investors who would like to invest in each other’s markets.










Photo: Dave Di Biase









The article also provided support for the hypothesis that international market correlations increase after unexpected exogenous shocks. The implication is that diversification benefits may be reduced after such events. The tests of stability of market co-movements were based on before and after analyses of the September 11, 2001, terrorist events in the United States.


In a follow-up article published in 2008, my co-author and I investigated same issue (global equity market integration) but utilized data from five selected Exchange-Traded Funds (ETF) representing the U.S., Taiwan, Australia, Spain, and Austria during the period of 2001-2004.

The findings were in line with the earlier research in that while the interdependencies among the five markets are significant, there is still room for international portfolio diversification. For example, investing in Austria provides diversification benefits for American, Taiwanese, and Australian investors. Investors from Taiwan can realize benefits by investing in Europe and in Australia, but not in the U.S. On the other hand, Austrian investors can diversify portfolios by investing in the U.S., Taiwan, and Australia. Finally, the study of the effect of the Iraq war on the co-movement of the equity markets provided mixed results for the hypothesis that the international market correlations increase after an exogenous shock.

Finally, after the great recession of 2008-2010, the interest has shifted to the concept of volatility. Closer observers of the equity markets have been paying a lot of attention to volatility measures such as VIX index, known as the fear index. Typically, investors become optimistic when they think a stock is headed higher and turn bearish when they think the opposite. The VIX indicator works as a signaling device informing the investor whether or not the markets have reached an extreme position.

My current research (2012) investigates volatilities across different equity markets. If equity markets are in fact integrated, an unexpected event in one market may influence not only returns, but also volatility (measured by standard deviation) in the other markets. The analysis of volatility is particularly important because the information it provides for the riskiness of assets.

The sample includes the U.S. and Canada from North America; Germany from Europe, and China from Asia with the following ETFs: U.S.: SPY: The SPDR S&P 500 ETF. Canada: EWC. The period studied was January 2008-December 2010. After calculating daily volatilities and unidirectional correlation coefficients and applying MARMA (Multivariate autoregressive moving averages) to the resulting data, the results indicated that the U.S. market volatility measured by SPY had the most marked effect on the volatilities of the other market ETF. While both Canadian and German ETF volatilities seem important to explain the volatilities in other markets (U.S. and to a lesser extend China), the spillovers seem to become more pronounced as we moved from 2008 to 2010. The findings imply that investment and fund managers with access to news on other markets may react to changes faster than those who do not. In addition, the results also imply that investors should not only rely on current news to guide their investment decisions but also take into consideration international news for there are spillovers. Since volatilities can proxy for risk, there are implications for both individual and institutional investors in terms of further examining pricing securities, hedging, other trading strategies, and framing regulatory policies.

Click here for the original article: “Benefits of International Portfolio Diversification”

References:

Yavas, B.F and Rezayat, F “Integration among Global Equity Markets: Portfolio Diversification using Exchange-Traded Funds,” Investment Management & Financial Innovations, 5 (3) (2008): 30-43.

Yavas, B.F and Rezayat, F. “Market Volatility: A Study of Equity Markets of US, Canada, Germany and China.” Journal of Banking and Finance, Submitted, 2012.

About the Author(s)

Burhan F. Yavas, PhD, is an adjunct professor, working as a class advisor for Presidential Key Executive (PKE) MBA at the Graziadio School of Business and Management. He is also a professor in accounting and finance at California State University, Dominguez Hills (CSUDH). He consults for corporations and financial institutions in the areas of export-import management, market surveys business forecasting, and corporate strategy. He has lectured and written in a variety of publications, including the Management International Review, Journal of Multinational Financial Management, International Trade Journal, and Journal of Cross Cultural Management.

Comments

Mike Dever

August 11, 2012 at 12:44 pm

While international equity positions can diversify a U.S. concentrated equity portfolio, it can never provide ‘true’ portfolio diversification. The issue/question isn’t one of whether people should diversify into stocks of companies domiciled in other countries, but what constitutes portfolio diversification. Limiting a portfolio to long stock positions (regardless of location) or bonds and real estate does not create true portfolio diversification. That is because, as I point out in my book, stocks do become highly correlated with each other during “Angry Environments,” those periods where people shun stocks. I present the actual correlation tables in this chapter, which I am happy to provide a complimentary link to: http://bit.ly/vqunLV
True portfolio diversification can only be achieved by replacing “asset classes” (such as stocks, bonds and real estate) with “return drivers” and “trading strategies.” I show n example of the performance of a truly diversified portfolio in the book’s final chapter: http://bit.ly/vxDo6v