The Effectiveness Of International Diversified Stock Portfolio

With the integration of international financial markets, more and more investors start to diversify their portfolios internationally. In this paper, several empirical tests are applied to evaluate the effectiveness of international diversified stock portfolios in bull and bear markets as well as the potential gains of diversification strategies for both developed and developing country investors. I have investigated the performance of a set of twenty-five stock market indices which include twelve developed countries and thirteen developing countries. The sampling periods are divided into six stages and contain the three major global economic recessions in the past fifteen years. The three depressions are triggered by the Asian Financial Crisis, the Terrorist Attack of September 11th and the Subprime Mortgage Crisis, respectively.The fundamental descriptive statistics indicates that developed stock market indices are generally featured as low return and low risk while emerging market indices are more likely to provide extreme returns and a relatively high degree of volatility. The diversification strategy is potentially beneficial in two different ways. By constructing an international diversified portfolio, investors from mature markets can acquire a higher return and investors of emerging markets will reduce their investment risk. However, a passively diversified international stock portfolio limits the upward potential of returns. An active management should be applied by those aggressive investors who are less risk adverse.In this research, the correlation matrices are built up for market indices returns over the six sampling periods. The correlation coefficients between neighbor countries or countries with strategic alliances are inclined to be higher than others. The application of a Z-statistic hypothesis test proves that the correlation structure of global equity market returns is not constant over time. Correlation coefficients rise during economic crisis and decline again when the crash is over. However, they don’t drop back to the original level as before the crisis. That is because the correlations among markets increase with the passage of time even if no economic fluctuation happens. The total risk of foreign investment can be decomposed into the local stock return risk and the currency risk. The quantitative analysis concludes that the risk of local stock returns dominates the currency ratio changes. The currency risk is not significant in a fully diversified international portfolio. But, investors usually have a higher currency risk on financial assets in emerging markets than in developed markets. That is because, an economic crisis tends to make the stock price and currency value decline simultaneously in the emerging market. The contribution of currency risk to total risk is positive. Without hedging, investors are likely to suffer both decreasing local asset returns and decreasing foreign exchange value, thus magnifying their investment loss. Comparatively, the stock returns and currency movements are reverse in mature markets. The appreciation of local currency will partially offset the loss on stock value. The contribution of currency risk to total risk is negative, so diminishing the volatility of investment return. Additionally, the research proves that Chinese equity market is a heaven for global investors, as the return on Chinese stock market index is low correlated with most countries in both bull and bear periods. Furthermore, considering that the fluctuation of CNY/USD exchange ratio is limited during a short horizon, US investors needn’t worry much about currency risk if they want to make a short-term investment in Chinese stock market.Finally, an equal-weighted international portfolio is constructed to make a comparison between the Sharpe Ratios of the international and pure domestic portfolio. It concludes that US investors accrue potential diversification gains in terms of return enhancement. US international portfolio works efficiently under good economic conditions rather than bad ones. In China, the great reduction of volatility is the main benefit from diversified investment. However, the decrease on return offsets the decrease on standard deviation, making the performance of international portfolios no better than that of domestic investment.To summarize, this study adds to the existing literature by two contributions. Firstly, the research applies a multi-period approach. More than one economic expansion and recession is tested in order to increase the reliability and universality of the test results. Secondly, not like the previous studies that focus on the benefits to US investors, this paper has measured the different effectiveness of international diversified portfolios to investors in various countries.There are three major limitations on the research in this paper. One is that the conclusions above are only applicable to a relatively short-term investment without a great change of economic conditions. If the time horizon is long enough to cover more than one bull or bear period, some statements will be deviated. Another limit is that the heteroscedasticity of correlation coefficients caused by increased market volatility during the crisis period isn’t taken into consideration when calculating the correlation matrix, so might lead to some bias. Lastly, the equal-weighted portfolio composed in the research represents a passive investment strategy. If the investors are able to make an active management on the international portfolio, they will probably acquire better SHP results.