International portfolio construction

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International Portfolio Construction

Ex post studies have demonstrated that institutions could have benefited from international stock diversification. However, the potential gains from ex ante international diversification are dependent on the intertemporal stability of correlations between international security markets. Conclusions from intertemporal stability tests are mixed. More direct empirical tests to determine whether diversifying internationally is feasible for practitioners are provided. This paper illustrates the substantial progress in research on international portfolio management over the last 15 years, and identifies related areas in which further advancement is possible. Investment text authors often rely on international finance text authors to cover international portfolio construction, and vice versa. This paper fills the gap by providing a review of empirical work on the construction of international equity portfolios. Review

of Internationally

Diversified

Equity

Portfolios

With regard to intercounty equity investing, Grubel’s [ 181 seminal work is an appropriate introduction, since his contribution stimulated the interest of others in this area. Grubel analyzed stock indices of various countries and found that a diversified portfolio of international stock indices dominated the U.S. index in terms of risk and return. Specifically, the Japanese, South African, and Australian indices received large allotments in defining the efficient portfolios within an ex post setting. To demonstrate the importance of these three indices, Grubel did a second analysis excluding them and discovered that the gains from international diversification still existed but were reduced substantially. In a related study, Levy and Sarnat [35] utilized country stock indices to construct efficient portfolios in an ex post framework. Like Grubel, they discovered that the Japanese and South African indices played a vital role in the efficient portfolios. Levy and Sarnat explained these results by illustrating the pairwise correlation coefficients among countries, which showed that Japanese and South African equity returns were not highly correlated with those of other countries. Conversely, many of the larger industrialized countries’ stock index returns were more highly correlated with each other. Levy and Sarnat suggested that this is due to fewer restrictions on their capital flows, which may allow the economic conditions of these countries to interact and influence

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Journal of Business Research 13, 87-95 (1985) 0 Elsevier Science Publishing Co., Inc. 1985 52 Vanderbilt Ave., New York, NY 10017

Madura,

Finance

Department,

University

of Central

Florida,

0148-2963/85/$3.30

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each other. As a result, diversification of stock investments among countries with fewer capital flow restrictions is not as beneficial. The correlation matrix displayed very close relationships among the stock indices of all Common Market countries. This implies that investors need not include more than one of these countries within their portfolio to achieve sufficient risk reduction capability. Grubel and Fadner [ 191 extended the analysis of intercountry correlation coefficients to consider various time horizons. They hypothesized that correlations among stock indices would be higher for longer holding periods. This hypothesis can be derived from the expectation that returns are influenced by random factors (financial news, speculation) in the short run, but such random factors would be dominated by real factors (economic growth, prices, profits) in the long run. Thus, if the real factors are at all related among countries, the indices should be related as well. To test this hypothesis, intercountry correlations of weekly, monthly, and quarterly holding periods were compared. Correlations were highest for quarterly returns and lowest for weekly returns, confirming the hypothesis. Shares within a country also reacted in a similar manner. That is, they were more highly correlated for longer holding periods. However, the percentage increase in correlation due to a longer holding period was not as high for intracountry stocks as for intercountry indices. The results of Grubel and Fadner’s analysis suggest that the potential gains from investing across countries is less for longer holding periods. The three articles summarized above laid the foundation for examinations of international equity diversification. The comovements of international stock indices have also been analyzed by multivariate methods which provide a measure of commonality. For example, Ripley [45] surveyed international equity markets during the 1960s to search for systematic variation patterns. He employed factor analysis to explore interrelationships among the stock indices. Countries such as the United States, Canada, Switzerland, and the Netherlands were found to have a low degree of unique variability. At the other extreme, the countries with the highest levels of unique movement included South Africa and Japan. In a related study, Panton, Lessig, and Joy [44] used numerical taxonomy (cluster analysis) to examine similar relationships among stock indices. Their findings were quite similar to those of Ripley with regard to the degree of correlation among countries. Both of these studies cite the importance of Japan and South Africa in efficient portfolio construction of international stock indices. Errunza [ 121 applied the work of Grubel, Levy, and Sarnat and Grubel and Fadner on international stock diversification of less developed countries. He demonstrated that internationally diverse portfolios of such country indices dominated a U.S. stock index over the data periods examined. These results coincide with the conclusions derived from the earlier studies. All the research reviewed up to this point was based on a U.S. investor’s viewpoint. If exchange rates were perfectly stable over time and no other imperfections existed, the results would hold regardless of the investor’s perspective. However, even during the fixed exchange rate period, exchange rates were not perfectly stable. Thus, the ability to gain through diversification may vary among investor perspectives. Analyses by McDonald [39], Solnik [SS] , Findley and Smith [14], Saunders and Woodward [47], Guy [20], and Biger [8] have considered viewpoints of investors outside of the United States. McDonald examined French mutual funds and discovered that performance for a French investor was superior for the internationally diversified funds. Solnick investigated the foreign markets over the 1966-1971 period. Unlike most of the researchers on this topic, he examined actual stocks rather than country indices. Solnik’s analysis led him to conclude that international diversification is attractive regardless of the investor’s

Portfolio Construction

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home country. He found this to be true whether exchange rate changes are hedged or uncovered. Because the ex post studies on international portfolio construction reviewed below were conducted subsequent to the floating exchange rate period, the authors considered exchange rate-adjusted stock returns. While some studies repeated their methodology for unadjusted exchange rate changes (as if the investor had hedged against exchange rate risk), the results were generally similar. Findlay and Smith examined intercountry indices from the viewpoint of the Canadian investor and illustrated gains through international diversification with an ex post framework. Saunders and Woodward examined exchange rate-adjusted stock indices from the British investor’s perspective. They found that an equally weighted international portfolio outperformed the British index. In addition, the efficient frontier was derived. Surprisingly, the frontier consisted of only one portfolio, which was composed of an all-Japanese index. That is, the Japanese index had a lower variance than any other portfolio and also yielded the highest return to the British investor. Guy compared British investment trusts, some of which were internationally diversified, to the London Stock Exchange index. Unlike all of the other evidence presented up to this point, the internationally diversified portfolios were outperformed by the domestic index. This may be due to Guy’s consideration of tax effects. The London Stock Exchange stocks can be perceived as buy-and-hold stocks, whereas the trust portfolios are often modified, resulting in higher turnover taxes. A related study by Biger [8] examined various indices over the 1966-1976 period. This study improved on previous research in that correlations were analyzed from the viewpoint of investors in a variety of countries. The correlations were shown to differ depending on the investor’s home country. As a consequence, the efficient frontiers derived by Biger also varied with the investor’s national perspective. Biger demonstrated that investors from any country could have gained through international diversification. The works of Grubel, Levy and Sarnat, Grubel and Fadner, Errunza, Saunders and Woodward, and Biger have made distinguished contributions in suggesting potential gains through international stock diversification. These studies share two common elements: 1) use of an ex post framework within the methodology, and 2) demonstration that internationally diverse portfolios dominate the domestic index in an ex post sense. While their work sufficiently achieved their intentions, they lead us to an important questionwhy haven’t investors taken advantage of international stock markets? Market imperfections may serve as a general answer. Specific imperfections have been identified in several studies. Cohn and Pringle [ 1 l] suggested that the more open a stock market is to capital flows, the higher will be its correlation with other markets. Thus, when the markets are open to cash flows, gains are reduced. For countries with more restrictions on capital flows, their markets are less correlated (a desirable aspect), but are also difficult to invest in. McDonald [39] and Guy [20] contended that these controls on capital flows are nontrivial in some cases and can discourage international diversification efforts. Lloyd [36] stated that investors could avoid the controls by concentrating their efforts on welldeveloped foreign markets in stable countries. However, the bulk of the literature reviewed has demonstrated that gains from international diversification have been fully realized only when markets with more restricted capital flows were included. Another imperfection vital to the investigative question is information. McDonald mentioned that a given country may incur costs in learning about the companies of other countries. A second type of information imperfection is future exchange rates, which can have a significant impact on foreign investment returns. Of course, domestic investments are insulated from this risk. Saunders and Woodward [47] , Bertoneche [4] , and Biger

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[8] analyzed correlation coefficients from both adjusted stock returns (adjusted for exchange rate changes) and unadjusted returns. They found only minor differences. This implies that the existence of fluctuating exchange rates should not have a substantial impact on the composition of efficient portfolios. However, the performance of the efficient portfolios may be significantly affected by exchange rate changes even if the composition is not. A third type of information imperfection concerns knowledge of the future stock correlations. This is common to domestic as well as international markets. Bicksler [6] emphasized that the intertemporal movements of intercountry correlations should be investigated. If correlations are unstable, the gains through international diversification may not necessarily be realized. In addition, Bicksler advised that an ex ante study of this topic be conducted to provide more practical implications. Although his suggestions focused on Errunza’s study regarding stock indices of less developed countries, they can be applied to much of the work dealing with international stock diversification. The following review applies to Bicksler’s suggestions for 1) a correlation stationarity test’ and 2) ex ante analysis. His first suggestion has met with reasonable success; unfortunately, the second has, in general, been ignored. Several researchers have examined the inter-temporal patterns of correlation coefficients. Makridakis and Wheelwright [41] discovered that intercountry correlations were always less than 1, an important criterion for diversification feasibility. However, they noticed that these correlations were generally unstable over time, Furthermore, no systematic pattern was discerned for predicting future correlations. This led the authors to conclude that achievement of gains from international diversification beyond what is possible domestically may be difficult. Panton, Lessig, and Joy [44] segmented their data in various ways and found that intertemporal changes in comovements are slight for the shorter subperiods but more pronounced for longer subperiods. Haney and Lloyd [22] split their data base of country stock indices into two subperiods. Correlation coefficients of quarterly returns were computed for all pairs of indices over both subperiods. They found that 23% of the pairwise correlations changed in a statistical sense. It is interesting and relevant to note that 90% of the changes were positive. This led to their conclusion that the diversification capability of internationally diversified portfolios may be weakening over time. However, only the correlations of the stock indices which are included in the investor’s portfolio would be relevant. Thus, if the component indices which make up the investor’s portfolio are within the subset that displayed stable correlations over time, the potential gains would not have been dampened in more recent periods. Bertoneche [4] discovered a higher segmentation (a weakened relationship) between intercountry correlations since the inception of floating rates in 1973. His finding of weakening interrelationships of stock markets over time are surprising (as he admits), since 1) the energy crisis had a general impact on most industrial countries, and 2) higher mobility of cash flows over time should have resulted in more interaction and influence among countries. His results conflict with those of Haney and Lloyd; this may be due to his choice of a weekly holding period for stock returns. Watson [58] segmented data on stock returns into various subperiods and tested the stability of their correlations. He found that 1 of 28 correlations was unstable in a statistical sense. The results showed very little detection of correlation instability over time, leading Watson to conclude that international diversification is plausible. A related study by Lloyd, Goldstein, and Rogow

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[37] found that 32% of the pairwise correlation coefficients changed significantly. All but one of the changes were positive. The most thorough test of intertemporal stability of intercountry correlation coefficients was conducted by Maldonado and Saunders [40] . They contended that splitting the data of international stock indices into two subperiods is a poor test of intertemporal stability, since only two samples of the entire population of correlation coefficients are compared. They used a data base of monthly returns for four stock indices from 1957 to 1978. The data were separated into 22 annual subperiods in which each country index correlation with the U.S. index was computed. The Box-Jenkins technique was employed to search for a lag relationship. No relationship was discerned. The runs test was also applied to the subperiod coefficients in order to search for dependencies over time. Three of the four correlation time series exhibited no lag relationships. The implications of this study are that intercountry correlations from ex post data do not provide valuable information for practitioners who make ex ante investment decisions. Maldonado and Saunders rearranged their data into 11 two-year subperiods and obtained similar results. In addition, two 1 l-year subperiods were compared; the results, in general, remained consistent. Finally, the data were segmented into quarterly subperiods, allowing for a sufficiently large set of time series correlation coefficients to search for higher-order dependencies. The authors found first- and second-order relationships, but randomness for all higher orders. Thus, they concluded that beyond two quarters, intercountry correlations are generally unstable. This conclusion places serious doubt on the feasibility of using a mean-variance model in deriving ex ante portfolios of international equities. The doubt is greater for longer horizons. The work of Maldonado and Saunders has improved upon previous research regarding intertemporal correlation stability in that 1) longer holding periods were utilized, which may fit the real world more appropriately, and 2) their statistical technique provided a search for higher-order dependencies. However, their analysis examined only four stock index relationships; further application to other pairwise correlations would yield more reliable implications. The research on intertemporal correlation movements provides relevant implications for ex ante decision making. However, the inferences to be drawn are somewhat limited because instability of correlations does not necessarily imply that ex post information on correlations is useless in an ex ante sense. Consider a case in which correlations change significantly from one period to another but retain some systematic relationship relative to other correlations. As an extreme case, it is possible that the composition of each efficient portfolio remains the same from one subperiod to the next even if all pairwise correlations change significantly, given that their movement is in a systematic direction. Unfortunately, very little research on international stock diversification has focused on its feasibility within an ex ante framework. Lessard [31] conducted an ex ante comparison of a naive (equally weighted) portfolio of four Latin American indices to the U.S. index over the 1959-1968 period. Overall, the Latin American portfolio outperformed the U.S. index. Errunza [12] used mean-variance efficient international portfolios derived from an ex post period as the investment decision for the subsequent period. The portfolio derived from the ex post data was superior to the GNP-weighted portfolio and did as well as the equally weighted portfolio. The two studies cited above do suggest that investment in internationally diversified stock portfolios can achieve ex ante gains beyond what is possible domestically. However, a more thorough empirical examination would provide stronger implications. The research reviewed up to this point suggests that international stock diversification appears to be beneficial because of the risk reduction capability of lowly correlated stock

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returns of various countries. However, market imperfections such as taxes on international transactions, government restrictions on markets, and lack of information discourage the idea. A possible solution to the dilemma is to purchase shares of a multinational corporation (MNCs). Because an MNC’s earnings may be affected by conditions within other countries, it may act as a substitute for an international stock portfolio. Yet, it is insulated from the market imperfections just mentioned, Agmon and Lessard [2] empirically examined share prices of MNCs. They hypothesized that MNCs would exhibit less systematic risk than national shares, since they represent more diversified operations. Their empirical tests confirmed this hypothesis. Similar conclusions were also drawn by Severn [5 I] and Rugman [46] . More recent work by Logue and Rogalski [38] and Mikhail and Shawky [42] also reinforce these conclusions. Logue and Rogalski discovered that while the average return to NMC shares was lower than that of national shares, on a risk-adjusted basis the MNC shares did outperform the national shares. Mikhail and Shawky randomly selected 30 MNC stocks and compared them to the Standard and Poor’s index. The average return of the MNC groups was higher for various holding periods. On a risk-adjusted basis, MNCs received a monthly return of 0.6% over what would be expected from a similar risk investment. Thus, abnormal risk-adjusted gains appear to be achievable when investing in MNC shares. Recent studies by Jacquillat and Solnik [26] and Senchak and Beedles [SO] empirically tested whether an investment in MNCs is a direct substitute for diversification among international shares. Both of these analyses resulted in a rejection of this hypothesis. Jacquillat and Solnik contended that MNC returns behave much like domestic returns. Senchak and Beedles concluded that while MNC shares may provide some advantages over national shares, they do not sufficiently replace international stock diversification. This issue remains unsettled.

Future

Empirically

Testable

Work in International

Portfolio

Construction

Perhaps the most vital missing link in past research is an ex ante view of international diversification. Diversification of stocks across countries (or currencies) was shown to be desirable within an ex post framework. Yet, the concept has not been fully operationalized from a practitioner’s point of view. Use of the mean-variance model for ex ante decisions can be empirically tested as follows. Only data prior to the holding period should be utilized to derive estimates of the returns, variances, and covariances of all available instruments. Data beyond the investment decision can then be used to evaluate the performance of the ex ante decision. The criteria are still risk and return. However, the variance may no longer serve as a suitable risk proxy. Risk from ex ante decisions may be most appropriately defined by some measure of deviation between actual and expected return. Variants of this deviation such as a semideviation might be proper for investors who are concerned only when the actual return is less than the expected return. The mean-variance model can be compared to other available alternatives such as a naive model to determine whether it could be useful to a practitioner. Of course, performance evaluation of one ex ante decision is not sufficient to derive reliable conclusions about a portfolio construction strategy. Ex ante decisions could be made on a periodic basis, with each decision using only information that is available at that time. The performance of a portfolio recommended by a particular strategy can then be assessed by the average realized return and the average deviation over all ex ante decisions. Another measure of risk for this approach is the standard deviation of realized returns over all ex ante holding periods.

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Whether ex ante gains from an international portfolio can be achieved may depend on the time horizon (holding period) of concern. In addition, the length of the data base used to estimate expected returns, variances, and pairwise covariances may affect the performance of the ex ante model. Further understanding of these two factors would result in a more accurate assessment of how an ex ante model should be operationalized for investment decisions.

The author wishes to thank two anonymous referees for their helpful comments.

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