International Diversification.docx

Chapter25: International DiversificationChapter OpenerPARTVIIp. 863ALTHOUGH WE IN the United States customarily use a broad index of U.S. equities as the market-index portfolio, the practice is increasingly inappropriate. U.S. equities represent less than 40% of world equities and a far smaller fraction of total world wealth. In this chapter, we look beyond domestic markets to survey issues of international and extended diversification. In one sense, international investing may be viewed as no more than a straightforward generalization of our earlier treatment of portfolio selection with a larger menu of assets from which to construct a portfolio. Similar issues of diversification, security analysis, security selection, and asset allocation face the investor. On the other hand, international investments pose some problems not encountered in domestic markets. Among these are the presence of exchange rate risk, restrictions on capital flows across national boundaries, an added dimension of political risk and country-specific regulations, and differing accounting practices in different countries. Therefore, in this chapter we review the major topics covered in the rest of the book, emphasizing their international aspects. We start with the central concept of portfolio theorydiversification. We will see that global diversification offers opportunities for improving portfolio riskreturn trade-offs. We also will see how exchange rate fluctuations and political risk affect the risk of international investments. We next turn to passive and active investment styles in the international context. We will consider some of the special problems involved in the interpretation of passive index portfolios, and we will show how active asset allocation can be generalized to incorporate country and currency choices in addition to traditional domestic asset class choices. Finally, we demonstrate performance attribution for international investments.25.1 Global Markets for Equitiesp. 864Developed CountriesTo appreciate the myopia of an exclusive investment focus on U.S. stocks and bonds, consider the data in Table 25.1. The U.S. accounts for only about a third of world stock market capitalization. Clearly, investors can attain better riskreturn trade-offs if they extend their search for attractive securities to both developed and emerging markets. Developed countries have broad stock indexes that are generally less risky than those of emerging markets, but both offer opportunities for improved diversification.1 Developed countries made up 68% of world gross domestic product in 2009. Our list also includes 20 emerging markets that make up 16.2% of the market capitalization of the world stock markets. The first six columns of Table 25.1 show market capitalization over the years 20042009 for developed markets. The first line is capitalization for all world exchanges, showing total capitalization of corporate equity in 2009 as $37.2 trillion, of which U.S. stock exchanges made up $12.3 trillion (33.1%). The next three columns of Table 25.1 show country equity capitalization as a percentage of the worlds in 2004 and 2009 and the growth in capitalization over the period. The large volatility of country stock indexes resulted in significant changes in relative size. For example, the U.S. weight in the world equity portfolio decreased from 42% in 2004 to 33% in 2009. The weights of the five largest countries behind the U.S. (Japan, U.K., France, Hong Kong and Canada) added up to 29% in 2009, so that in the universe of these six countries alone, the weight of the U.S. was only 54%. Clearly, U.S. stocks may not comprise a fully diversified portfolio of equities.The last three columns of Table 25.1 show GDP, per capita GDP, and equity capitalization as a percentage of GDP for the year 2009. As we would expect, per capita GDP in developed countries is not as variable across countries as total GDP, which is determined in part by total population. But market capitalization as a percentage of GDP is quite variable, suggesting widespread differences in economic structure even across developed countries. We return to this issue in the next section.Emerging MarketsFor a passive strategy one could argue that a portfolio of equities of just the six countries with the largest capitalization would make up 61.7% (in 2009) of the world portfolio and may be sufficiently diversified. This argument will not hold for active portfolios that seek to tilt investments toward promising assets. Active portfolios will naturally include many stocks or even indexes of emerging markets.Table 25.2 makes the point. Surely, active portfolio managers must prudently scour stocks in markets such as the so-called BRIC nations (Brazil, Russia, India, China). Table 25.2 shows data from the 20 largest emerging markets, the most notable of which is China with growth of 874% over the 5 years ending in 2009. But managers also would not want to have missed a market like Colombia (.36% of world capitalization) with a growth of 569% over the same years.These 20 emerging markets make up 24% of the world GDP and 16% of world market capitalization. Per capita GDP in these countries in 2009 was quite variable, ranging from $954 (Pakistan) to $18.576 (Czech Republic). Market capitalization as a percentage of GDP ranges from 12% (China) to 132% (South Africa), suggesting that these markets are expected to show significant growth over the coming years, even absent spectacular growth in GDP.p. 865Table 25.1Market capitalization of stock exchanges in developed countriesSources: Market capitalization, Datastream; GDP and per capita GDP, /library/publications/the-world-factbook/index.html.p. 866Table 25.2Market capitalization of stock exchanges in emerging marketsSources: Market capitalzation, Datastream; GDP and per capita GDP, /library/publications/the-world-factbook/index.html.p. 867Figure 25.1Per capita GDP and market capitalization as percent of GDP, 2009 (log scale)The growth of capitalization in emerging markets over 20042009 was very large (170%) and much more volatile than growth in developed countries, suggesting that both risk and rewards in this segment of the globe may be substantial.Market Capitalization and GDPThe contemporary view of economic development (see, for example, deSoto)2 holds that a major requirement for economic advancement is a developed code of business laws, institutions, and regulation that allows citizens to legally own, capitalize, and trade capital assets. As a corollary, we expect that development of equity markets will serve as a catalyst for enrichment of the population, that is, that countries with larger relative capitalization of equities will tend to be richer. Work by La Porta, Lopez-De-Silvanes, Shleifer, and Vishny indicates that, other things equal, market value of corporations is higher in countries with better protection of minority shareholders.3Figure 25.1 is a simple (perhaps simplistic, because other relevant explanatory variables are omitted) rendition of the argument that a developed market for corporate equity contributes to the enrichment of the population. The slope of the regression line shown in Figure 25.1 is .45, suggesting that an increase of 1% in the ratio of market capitalization to GDP is associated with an increase in per capita GDP of .45%. It is remarkable that only 2 of the 25 developed countries lie below the regression line; only 2 of 20 low-income emerging markets lie above the line. A country like Norway that lies above the line, that is, exhibits higher per capita GDP than predicted by the regression, enjoys oil wealth that contributes to population income. Countries below the line, such as Pakistan, suffered from deterioration of the business environment due to political strife and/or government policies that restricted the private sector.Home-Country BiasOne would expect that most investors, particularly institutional and professional investors, would be aware of the opportunities offered by international investing. Yet in practice, investor portfolios notoriously overweight home-country stocks compared to a neutral indexing strategy and underweight, or even completely ignore, foreign equities. This has come to be known as the home-country bias. Despite a continuous increase in cross-border investing, home-country bias still dominates investor portfolios. We discuss this issue further in Section 25.3.1FTSE Index Co. the sponsor of the British FTSE (Financial Times Share Exchange) stock market index uses 14 specific criteria to divide countries into “developed” and “emerging” lists. Our list of developed countries includes all 25 countries that appear on FTSEs list.2Hernando de Soto, The Mystery of Capital (New York: Basic Books, 2000).3Rafael La Porta, Florencio Lopez-De-Silvanes, Andrei Shleifer, and Robert Vishny, “Investor Protection and Corporate Valuation,” Journal of Finance 57 (June 2002).25.2 Risk Factors in International Investingp. 868Opportunities in international investments do not come free of risk or of the cost of specialized analysis. The risk factors that are unique to international investments are exchange rate risk and political risk, discussed in the next two sections.Exchange Rate RiskIt is best to begin with a simple example.Example 25.1 Exchange Rate RiskConsider an investment in risk-free British government bills paying 10% annual interest in British pounds. While these U.K. bills would be the risk-free asset to a British investor, this is not the case for a U.S. investor. Suppose, for example, the current exchange rate is $2 per pound, and the U.S. investor starts with $20,000. That amount can be exchanged for 10,000 and invested at a riskless 10% rate in the United Kingdom to provide 11,000 in 1 year.What happens if the dollarpound exchange rate varies over the year? Say that during the year, the pound depreciates relative to the dollar, so that by year-end only $1.80 is required to purchase 1. The 11,000 can be exchanged at the year-end exchange rate for only $19,800 (= 11,000 $1.80/), resulting in a loss of $200 relative to the initial $20,000 investment. Despite the positive 10% pound-denominated return, the dollar-denominated return is a negative 1%.We can generalize from Example 25.1. The $20,000 is exchanged for $20,000/E0 pounds, where E0 denotes the original exchange rate ($2/). The U.K. investment grows to (20,000/E0)1 + rf(UK) British pounds, where rf(UK) is the risk-free rate in the United Kingdom. The pound proceeds ultimately are converted back to dollars at the subsequent exchange rate E1, for total dollar proceeds of 20,000(E1/E0)1 + rf(UK). The dollar-denominated return on the investment in British bills, therefore, is We see in Equation 25.1 that the dollar-denominated return for a U.S. investor equals the pound-denominated return times the exchange rate “return.” For a U.S. investor, the investment in British bills is a combination of a safe investment in the United Kingdom and a risky investment in the performance of the pound relative to the dollar. Here, the pound fared poorly, falling from a value of $2.00 to only $1.80. The loss on the pound more than offset the earnings on the British bill.Figure 25.2 illustrates this point. It presents rates of returns on stock market indexes in several countries for 2009. The colored bars depict returns in local currencies, while the dark bars depict returns in dollars, adjusted for exchange rate movements. Its clear that exchange rate fluctuations over this period had large effects on dollar-denominated returns in several countries.p. 869Figure 25.2Stock market returns in U.S. dollars and local currencies, 2009CONCEPTCHECK1Using the data in Example 25.1, calculate the rate of return in dollars to a U.S. investor holding the British bill if the year-end exchange rate is: (a) E1 = $2.00/; (b) E1 = $2.20/.Pure exchange rate risk The uncertainty in asset returns due to movements in the exchange rates between the dollar and foreign currencies. is the risk borne by investments in foreign safe assets. The investor in U.K. bills of Example 25.1 bears the risk of the U.K./U.S. exchange rate only. We can assess the magnitude of exchange rate risk by examining historical rates of change in various exchange rates and their correlations.Table 25.3A shows historical exchange rate risk measured from monthly percentage changes in the exchange rates of major currencies over the period 20002009. The data show that currency risk can be quite high. The annualized standard deviation of the percentage changes in the exchange rate ranged from 9.65% (Canadian dollar) to 13.84% (Australian dollar). The annualized standard deviation of returns on U.S. stocks for the same period was 17.08%. Hence, currency exchange risk alone would amount to between 57% and 81% of the risk on U.S. stocks. Clearly, an active investor who believes that Australian stocks are underpriced, but has no information about any mispricing of the Australian dollar, would be advised to hedge the dollar risk exposure when tilting the portfolio toward Australian stocks. Exchange rate risk of the major currencies seems fairly stable over time. For example, a study by Solnik for the period 19711998 finds similar standard deviations, ranging from 4.8% (Canadian dollar) to 12.0% (Japanese yen).4 p. 870Table 25.3Rates of change in the U.S. dollar against major world currencies, 20002009Sources: Exchange rates: Datastream; LIBOR rates: .In the context of international portfolios, exchange rate risk may be partly diversifiable. This is evident from the relatively low correlation coefficients in Table 25.3B. (This observation will be reinforced when we compare the risk of hedged and unhedged country portfolios in a later section.) Thus, passive investors with well-diversified international portfolios may not need to hedge 100% of their exposure to foreign currencies.The annualized average change in the value of the U.S. dollar against the major currencies over the 10-year period and dollar returns on foreign bills (cash investments) appear in Table 25.3C. The table shows that the value of the U.S. dollar consistently depreciated in this particular period. For example, the average rate of depreciation against the euro over the 10 years was 2.98%. Had an investor been able to forecast these large exchange rate movements, it would have been a source of great profit. The currency market thus provided attractive opportunities for investors with superior information or analytical ability.The investor in Example 25.1 could have hedged the exchange rate risk using a forward or futures contract on foreign exchange. Recall that a forward or futures contract on foreign exchange calls for delivery or acceptance of one currency for another at a stipulated exchange rate. Here, the U.S. investor would agree to deliver pounds for dollars at a fixed exchange rate, thereby eliminating the risk involved with conversion of the pound investment back into dollars.p. 871Example 25.2 Hedging Exchange Rate RiskIf the forward exchange rate in Example 25.1 had been F0 = $1.93/ when the investment was made, the U.S. investor could have assured a riskless dollar-denominated return by arranging to deliver the 11,000 at the forward exchange rate of $1.93/. In this case, the riskless U.S. return would then have been 6.15%:You may recall that the hedge underlying Example 25.2 is the same type of hedging strategy at the heart of the spot-futures parity relationship first discussed in Chapter 22. In both instances, futures or forward markets are used to eliminate the risk of holding another asset. The U.S. investor can lock in a riskless dollar-denominated return either by investing in United Kingdom bills and hedging exchange rate risk or by investing in riskless U.S. assets. Because investments in two riskless strategies must provide equal returns, we conclude that 1 + rf(UK)F0/E0 = 1 + rf(US), which can be rearranged to This relationship is called the interest rate parity relationship The spot-futures exchange rate relationship that prevails in well-functioning markets. or covered interest arbitrage relationship See interest rate parity relation., which we first encountered in Chapter 23.Unfortunately, such perfect exchange rate hedging usually is not so easy. In our example, we knew exactly how many pounds to sell in the forward or futures market because the pound-denominated return in the United Kingdom was riskless. If the U.K. investment had not been in bills, but instead had been in risky U.K. equity, we would have known neither the ultimate value in pounds of our U.K. investment nor how many pounds to sell forward. The hedging opportunity offered by foreign exchange forward contracts would thus be imperfect.To summarize, the generalization of Equation 25.1 for unhedged investments is that where r(foreign) is the possibly risky return earned in the currency of the foreign investment. You can set up a perfect hedge only in the special case that r(foreign) is itself a known number. In that case, you know you must sell in the forward or futures market an amount of foreign currency equal to 1 + r(foreign) for each unit of that currency you purchase today.CONCEPTCHECK2How many pounds would the investor in Example 25.2 need to sell forward to hedge exchange rate risk if: (a) r(UK) = 20%; and (b) r(UK) = 30%?Political RiskIn principle, security analysis at the macroeconomic, industry, and firm-specific level is similar in all countries. Such analysis aims to provide estimates of expected returns and