Does International Diversification Pay?

Does Internatonal Dversfcaton Pay? Vvek Bhargava 1, Danel K. Konku, and D. K. Malhotra 3 Advances computer and telecommuncatons technology have contrbuted to the emergence of more tegrated global fancal markets, allowg for the dssematon of formaton and the executon of transactons on a real-tme bass around the clock and around the globe. To determe f an vestor can ga addtonal dversfcaton benefts by vestg today s creasgly tegrated global fancal markets, returns on four dfferent dexes Standard & Poor s Composte 500 (S&P 500); Morgan Stanley Captal Internatonal (MSCI) World Index; Europe, Australa, and Far East (EAFE) Index; and the MSCI Europe Index are analyzed for a -year perod, from 1978 to 000. Although the benefts from ternatonal dversfcaton are decreasg, an vestor s better off vestg a porton of hs or her portfolo ternatonal markets, especally the European markets. Keywords: Dversfcaton, Mutual fund selecton, Rsk reducton Introducton Globalzaton of fancal markets s one of the most sgnfcant economc developments over the last decade. Advances computer and telecommuncatons technology contrbuted to the emergence of global fancal markets, permttg the dssematon of formaton and executon of transactons on a real-tme bass around the clock and around the globe. As a result, cross-border fancal transactons exploded, and global markets became more tegrated the 1990s. In addton to ts mpact on other mportant ssues fance, ths development s havg far-reachg mplcatons for portfolo strateges. Expandg lks between natonal economes and creasg traregonal trade, combed wth the explosve growth cross-border portfolo vestment, are creatg a world whch stock markets move together to a consderable extent, thus nullfyg/reducg the benefts of a global mx of securtes. Prevous studes have establshed the benefts of global dversfcaton. Ths study revsts the ssue of global dversfcaton to determe f the benefts of dversfyg portfolos ternatonally exst even when markets are becomg creasgly tegrated around the globe. The obectve of ths paper s to determe whether an vestor today can stll ga dversfcaton benefts by vestg ternatonal markets. The monthly returns of four dfferent dexes--standard & Poor s 500 (S&P 500); Morgan Stanley Captal Internatonal (MSCI) World Index; the Europe, Australa and Far East (EAFE) Index; and the MSCI Europe Index are analyzed over a -year perod, from 1978 to 000. Portfolos of domestc and ternatonal dexes are developed to determe f ternatonal dversfcaton enhances portfolo performance and effcent fronters are developed to determe the mmum-varance portfolos for the vestor. In addton, portfolo returns for the last 10 years of the perod, 1991 to 000, and the last fve years, 1996 to 000, are examed to test the popular contenton that the benefts of ternatonal dversfcaton are steadly decreasg due to the creasg tegraton of global fancal markets. An vestor can vest ternatonal markets a number of ways, cludg buyg foregn company stocks on foregn exchanges, buyg stocks multatonal companes, buyg ternatonal mutual funds, or buyg dexed funds. A typcal U.S. vestor mght fd t dffcult to dentfy good 1 Vvek Bhargava, Assstant Professor of Fance, Alcorn State Unversty, MBA Program, 15 Campus Drve, Natchez, MS 3910, phone 601-304-4319, e-mal, vvek@lorman.alcorn.edu Danel K. Konku, Department of Fance, Florda Atlantc Unversty, 777 Glades Rd., Boca Raton, FL 33431-0991; phone 954 991 001; e-mal, dkonku@yahoo.com 3 D. K. Malhotra, Assocate professor of Fance, Phladelpha Unversty, School of Busess Admstraton, School House Lane and Henry Avenue, Phladelpha, PA 19144-5497, phone 15-951-813; fax: 15-951-65; e-mal, malhotrad@phlau.edu 004, Assocaton for Fancal Counselg and Planng Educaton. All rghts of reproducton any form reserved. 53

Fancal Counselg and Planng Volume 15 (1), 004 stocks tradg on foregn exchanges. Most vestors today buy mutual funds. It may be even better to buy dex funds to acheve the full benefts of dversfcaton. Index funds of the dexes analyzed ths paper are readly avalable, have relatvely low expense ratos, and are easly accessble to vestors. When vestg ternatonal markets, vestors need to remember that they are exposed to exchange rate rsk. However, most cases, the effect of exchange rate changes on a frm s return on vestment wll be sgnfcant because multatonal frms use varous hedgg struments, cludg forwards, futures, optons, and swaps. Furthermore, a frm can have a well-balanced foregn exchange portfolo wth long and short postons smlar, hghly correlated currences. These hedgg actvtes appear to be effectve and those frms usg currency dervatves can reduce ther exposure to exchange rate rsk. Furthermore, poltcal rsk has a profound fluence on foregn vestment, gven that stablty a host country s government or monetary/fscal polces results more uncerta vestment outcomes. In the context of the Captal Asset Prcg Model (CAPM), the concern s the poltcal rsk that cannot be dversfed away by holdg a market portfolo of all assets. By mplcaton, f a type of poltcal rsk s dversfable, then t wll not affect vestors requred return or the frm s captal cost. On the contrary, f many or all assets share poltcal rsk, then the requred return wll reflect ths nondversfable rsk. The challenge s determg whether any partcular poltcal rsk s dversfable or not. Butler and Domgo (1998) suggest that ths depends on the relevant market portfolo agast whch nondversfable rsk s measured. Ths, turn, depends on the degree of tegraton or segmentaton the captal markets whch the vestment s made. When captal markets are well tegrated, the relevant portfolo s the global market portfolo, and when a domestc market s segregated from other captal markets, the relevant portfolo s the domestc market. Recent research has concentrated on the dversfcaton benefts from emergg markets, but ths paper analyzes dexes from developed markets, where the rsks assocated wth vestment are relatvely low. Ths study s mportant for practtoners, as t documents the mpact of tegraton on the benefts of dversfcaton by comparg the results for the last years to those from the last fve years. Ths paper also makes a recommendaton to the vestor on the percentage of the portfolo that should be allocated to ternatonal vestments, as well as on the weghts for the mmum-varance portfolo. Untl recently the cost of vestg ternatonal markets was a concern to the vestors. But today a number of dexed and other mutual funds are avalable through establshed mutual fund companes the US and the expense ratos of these funds are relatvely low. Lterature Revew Even though cross-border tradg has been place for a few hundred years, real evdence of the desrablty of corporatg the securtes of less developed countres to dversfed portfolos was not documented untl the early 1970s, studes conducted by Levy and Sarnat (1970), Lessard (1973), and Errunza (1977). The case was also strongly recommended by Bergstrong (1975). Sce then, many researchers have descrbed the rsk reducton and return enhancement of carefully dversfed portfolos across dfferent ternatonal equty markets. In recent analyses of emergg markets, Harvey (1993, 1995) exames the mpact of emergg equty markets on global vestment strateges. Hs results corroborate the fdgs of past studes, whch suggested that theoretcal gas exsted from dversfcaton to emergg stock markets because of a shft the mean-varance effcent fronter. Regresson-based mean varance spanng was troduced to the fance lterature by Huberman and Kandel (1987). Sce then, a number of researchers have used ths methodology to test for benefts of dversfcaton. Bekaert and Uras (1996) exame closed-end funds for emergg markets and fd sgnfcant benefts for U.K. country funds but not for U.S. funds. De Roon, Nman, and Werker (001) fd that the absence of market frctons there are advantages to dversfcaton emergg markets, but these benefts dsappear wth short sales constrats and vestablty restrctons. Dressen and Laeven (003) fd that the absence of short sales restrctons, dversfcaton benefts are avalable to all countres, but decrease wth the restrcton on short sales mposed. They also fd that the benefts are largest for developg countres and for countres wth hgh country rsk. Results by Dwan, Errunza, and Senbet (1995) further dcate that those frms already dversfed across developed markets can stll mprove the performance of ther portfolos sgnfcantly by vestg the stock of emergg economes. 54 004, Assocaton for Fancal Counselg and Planng Educaton. All rghts of reproducton any form reserved.

Does Internatonal Dversfcaton Pay? The benefts from dversfcaton have often been analyzed the classcal mean-varance framework, whch assumes that the requred puts to the analyss (returns, varances, and covarances) are known wth certaty. Emprcal studes that rely on these assumptons do not reflect the realtes under whch vestment decsons are made (Errunza, 1977; Baley and Stulz, 1990). The non-statonary nature of the puts renders the selecton of an optmal vestment strategy dffcult to acheve. Gven the fluctuatg nature of emergg-market returns, Eftekhar and Satchell (1999) vestgate whether the tradtonal sgle-factor mean-varance CAPM s stll vald. They consder an alternatve CAPM: the lower partal moment CAPM (LPM- CAPM), whch dffers from the mean-varance CAPM the presence of non-normalty. The researchers show that for vestors, most cases, emergg-market betas from LPM-CAPM are not emprcally dfferent from those derved from the tradtonal mean-varance CAPM. As stated earler, a number of other researchers have also used the mean-varance approach. Kohers, Kohers, and Pandey (1998) fd that vestors can reap the benefts of dversfcaton emergg markets by vestg ust a few countres. These benefts are not senstve to weghts, and portfolos of approxmately equal weght produce adequate results. Aello and Cheffe (1999) analyze returns on seven dfferent dexes and fd that even though ternatonal vestment does not outperform the S&P 500, dversfcaton benefts stll exst. Ho, Mlevsky, and Robson (1999) fd that, unlke for U.S. vestors, ternatonal dversfcaton benefts for Canadan vestors are sgnfcant due to the reducton shortfall rsk. Usg dustry portfolo returns to represent dustry factors and country returns for natonal factors, early papers by Grold et al. (1989) were unable to expla the mpact of the two components on portfolo returns. However, Zervos (1996) was more successful her attempt to quantfy the mportance of country and dustry components dvdual stock returns over the perod 1976-9. She fds that, although both country- and dustry-specfc effects are mportant factors understandg emerggmarket returns, dustry effects expla lttle of the cross-sectonal dfferences returns and return volatlty; the low correlatons between varous markets are prmarly due to country-specfc factors. Despte all the evdence provded above, a number of academcans and practtoners beleve that, wth the world becomg more global, the correlatons between dfferent countres have creased and the benefts of ternatonal dversfcaton have sgnfcantly decreased. Furthermore, there s a belef that when the markets are movg down the U.S., the correlatons between the Unted States and varous countres crease and therefore ternatonal dversfcaton do not work when t s needed most. Hanna, McCormack, and Perdue (1999) examed the rsk-and-return effect that would have been realzed by a U.S. vestor who was vestg the fancal market dexes of the other G-7 natons Canada, the Unted Kgdom, France, Germany, Italy, and Japan. Usg data from 1988 to 1997, they found that dversfcaton does not happen wth enough frequency across the decade studed to ustfy the asserton that foregn gas wll compensate for domestc losses. Later, Chernoff (00) quotes a paper showg that the benefts of ternatonal dversfcaton depend on the tme perod studed, gven that these benefts come and go. Therefore, ths paper monthly data on the abovementoned dexes are analyzed to determe f t s stll frutful to vest ternatonal markets and whether an vestor would be better off vestg only developed countres, European countres, or the world markets, whch clude emergg markets as well. Most of the prevous lterature, especally from the 1980s and 1990s, has concentrated on the emergg markets, whch are rsker than the developed markets. In ths paper, the focus s on developed markets, whch are cheaper, easer, and less rsky. If vestors can reap dversfcaton benefts developed markets, they do not have to vest the rsker emergg markets. Emergg markets are mplctly cluded through the MSCI World Index. Data And Methodology Data Monthly data are obtaed for the years 1978 to 000 from Global Fancal Data. Monthly returns for the last years are examed to determe f t s better to vest domestc markets or world markets and so reap the benefts of ternatonal dversfcaton. The returns of dfferent dexes: S&P 500; MSCI World Index; Europe, Australa, and Far East (EAFE) Index; and the MSCI Europe Index are analyzed. The U.S. long-term bond rate s used as a proxy for the rsk-free rate. 004, Assocaton for Fancal Counselg and Planng Educaton. All rghts of reproducton any form reserved. 55

Fancal Counselg and Planng Volume 15 (1), 004 Methodology For each dex, the monthly returns are calculated as follows: Pt R t = ln *100 (1) P Where, t-1 R t = on dex month t P t = Value of dex at the end of month t P t-1 = Value of dex at the end of month t-1 R = Average( Rt ), s the average monthly return over the study perod The annualzed return for dex s calculated by: R ann = (1 + R ) 1 1 () Once the returns are calculated, the monthly standard devaton σ s calculated for each dex and annualzed usg: n σ = ( R) n 1 (3 a) t = 1 R t σ = 1 (3 b) ann σ Portfolos are created representg the S&P 500 and the ternatonal dexes order to calculate the comparatve return of each portfolo. For a multasset portfolo, return and the standard devaton are as follows: p R = w R + w R (4) σ = [( w σ ) + ( w σ ) + w w σ σ ρ ] portfolo Where, σ (5) = Standard devaton 1 For creatg portfolos of two dexes, the mmumvarance portfolo s found usg Equaton 6. σ Cov(, ) () = (6) σ + σ Cov(, ) W m In order to fd whch portfolo performed the best, the Sharpe rato, whch measures the returnvarablty rato, s used. A hgher Sharpe rato gves the hghest return per unt of rsk. R p r f ) σ ( Sharpe rato = Where r f s the rsk-free rate. p (7) Emprcal Results The returns of four dexes are analyzed: S&P 500, MSCI World Index, MSCI Europe Index, and the EAFE for a -year perod, from 1978 to 000. To dentfy recent trends, the returns for the last 10 years, 1991 to 000, and the last fve years, 1996 to 000 are examed. Varous combatons of portfolos that combe the ternatonal dexes wth the S&P 500 are analyzed order to draw effcent fronters. The Sharpe rato s used to determe f there are any benefts to dversfyg the ternatonal markets. Table 1 gves the correlatons between the average returns for varous pars of the selected dexes for the three tme perods. The correlatons between the S&P 500 and the EAFE, and between the S&P 500 and MSCI Europe, are low, averagg about 0.6 each case. The correlaton between the S&P 500 and the MSCI World Index s relatvely hgher, whch could be because the world dex cludes the U.S. markets. The farly low correlaton between the S&P 500 and EAFE, and between the S&P 500 and MSCI Europe dex, dcates that dversfcaton benefts can be acheved by formg portfolos consstg of these dexes. Also worth notg s that for all pars of dexes, the correlaton coeffcents crease for later perods, dcatg that the benefts of ternatonal dversfcaton are ether dsappearg or are not as pronounced as they used to be. Ths result appears to be due to creased expanson of global trade among natons recent years and the consequent tegraton of captal markets. w = of an vestment the portfolo ρ = Correlaton between vestment and vestment 56 004, Assocaton for Fancal Counselg and Planng Educaton. All rghts of reproducton any form reserved.

Does Internatonal Dversfcaton Pay? Table 1 Correlaton Matrx of s For Selected Indexes S&P World EAFE World EAFE Europe 0.8064 0.8538 0.9394 0.4936 0.5989 0.7347 0.6087 0.6545 0.6964 0.900 0.948 0.906 0.830 0.844 0.8467 0.899 0.8489 0.9035 Table gves the results of monthly and annualzed returns and standard devatons for the dvdual dexes, over the three tme perods. The S&P 500 provdes the hghest returns for all three perods, wth a 15.9 return the most recent fve-year perod (), dcatg that vestg a dversfed portfolo such as the S&P 500 yelds a greater return than any of the other dexes. Ths result s not surprsg gven the bull market the Unted States durg ths tme perod. Table Monthly and s for Selected Indexes S&P World EAFE Europe Monthly Mean Std. Dev..98 4.37 1.13 3.86 1.0 4.69.89.79.83.87.51.46.9.86 1.06 4.11 3.75 4.19 4.9 4.33 4.7 4.71 4.03 4.0 Mean Std. Dev. 11.76 15.13 14.44 13.38 15.91 16.6 10.71 9.89 10.48 10.48 6.30 5.6 10.99 10.86 13.51 14.5 1.98 14.53 17.04 14.78 15 16.3 13.94 14.54 For the whole perod, and for the last 10 years, the S&P 500 has domated the EAFE and the Europe dexes; that s, the S&P 500 has a hgher return and lower standard devaton than the other two dexes. The domance s not there for the last fve years, however, where the S&P 500 has a hgher return but a hgher standard devaton also. Just because the S&P 500 domates the two dexes does not mean that rsk reducton through dversfcaton cannot be acheved by combg these dexes wth the S&P 500. Portfolos contag varous combatons of the S&P 500 pared wth each of the ternatonal dexes are created to determe f any benefts can be derved from ternatonal dversfcaton and to fd portfolos wth the best performance the mean-varance framework. Table 3 gves the return, rsk, and Sharpe rato for varous combatons of portfolos between the S&P 500 and the selected global dexes for the perods. For a portfolo that combes the World Index wth the S&P 500. the mmum-varance portfolo contas 35 the S&P 500 and 65 the world dex. The effcent fronter cludes portfolos wth 35 or more vested the S&P 500 and 65 or less the world dex. Table 3 shows that the maxmum reward-to-rsk rato s derved when an vestor vests 100 the S&P 500 as dcated by the Sharpe rato. Based on ths crteron, an vestor s better off vestg domestcally rather than dversfyg the world markets, perhaps because the world dex cludes the U.S. markets. But for an vestor who has low tolerance for rsk, dversfcaton s stll helpful as the overall rsk decreases when the world dex s added to the S&P 500. A portfolo composed entrely of EAFE s effcent; t experences lower returns at hgher rsk than the portfolo consstg entrely of the S&P 500. However, the benefts of dversfcaton can stll be acheved. The mmum-varance portfolo conssts of 38 EAFE and 6 the S&P 500. The Sharpe rato s maxmzed when an vestor vests 90 the S&P 500 and 10 EAFE. Even though the S&P 500 domates the EAFE, vestors maxmze per unt return f they vest 10 of the portfolo EAFE markets. Ths result valdates the premse that ternatonal dversfcaton s benefcal to vestors. For the S&P 500 and the Europe dex, results aga, show that the S&P 500 domates the European returns, but there are benefts of dversfcaton as the overall rsk can be reduced. The mmum-varance portfolo conssts of 60 the S&P 500 and 40 the Europe dex. The mean-varance return s maxmzed when one vests 80 the S&P 500 and 0 the Europe dex. 004, Assocaton for Fancal Counselg and Planng Educaton. All rghts of reproducton any form reserved. 57

Fancal Counselg and Planng Volume 15 (1), 004 Table 3 and Rsk for Portfolos of Varous Combatons of S&P 500 wth Selected Indexes between S&P World MSCI World Index MSCI EAFE Index MSCI Europe Index Europe Std. Sharpe.Std. Sharpe Std. Sharpe Dev Rato EAFE Dev Rato Dev Rato 0.0 1.0 11.5 14.51 0.198 1.0 11.00 17.035 0.14669 1.0 11.57 16.34 0.198 0.1 0.9 11.36 14.074 0.035 0.9 11.14 16.13 0.16365 0.9 11.65 15.658 0.035 0. 0.8 11.48 13.956 0.135 0.8 11.8 15.349 0.1810 0.8 11.73 15.093 0.135 0.3 0.7 11.60 13.897 0.8 0.7 11.4 14.705 0.19875 0.7 11.8 14.639 0.8 0.4 0.6 11.71 13.899 0.31 0.6 11.56 14.18 0.1548 0.6 11.90 14.307 0.31 0.5 0.5 11.83 13.961 0.385 0.5 11.71 13.906 0.3047 0.5 11.99 14.106 0.385 0.6 0.4 11.95 14.083 0.447 0.4 11.85 13.780 0.483 0.4 1.07 14.04 0.447 0.7 0.3 1.06 14.63 0.497 0.3 11.99 13.845 0.5188 0.3 1.16 14.116 0.497 0.8 0. 1.18 14.499 0.537 0. 1.13 14.099 0.5736 0. 1.4 14.36 0.537 0.9 0.1 1.30 14.789 0.566 0.1 1.7 14.53 0.5941 0.1 1.33 14.666 0.566 1.0 0.0 1.41 15.18 0.585 0.0 1.41 15.18 0.585 0.0 1.41 15.18 0.585 Mmum Varance Portfolo.65 11.65 13.890 0.69.38 11.87 13.777 0.445.40 1.07 14.04 0.54 Fgure 1 Effcent Fronter: 1978--000 1.6 100 S&P 60 S&P and 40 Europe 1.4 1. 6 S&P and 38 Europe 1.0 35 S&P and 65 WORLD 11.8 11.6 11.4 100 Europe 11. 100 WORLD 11.0 100 EAFE 10.8 0.135 0.140 0.145 0.150 0.155 0.160 0.165 0.170 Rsk 58 004, Assocaton for Fancal Counselg and Planng Educaton. All rghts of reproducton any form reserved.

Does Internatonal Dversfcaton Pay? Table 4 and Rsk for Portfolos of Varous Combatons of S&P 500 wth Selected Indexes between S&P World MSCI World Index MSCI EAFE Index MSCI Europe Index Europe Std. Sharpe.Std. Sharpe Std. Sharpe Dev Rato EAFE Dev Rato Dev Rato 0.0 1.0 9.89 1.983 0.460 1.0 6.30 15.00-0.044 1.0 10.86 13.943 0.5161 0.1 0.9 10.35 1.845 0.841 0.9 7.11 14.343 0.0459 0.9 11. 13.46 0.549 0. 0.8 10.80 1.747 0.319 0.8 7.93 13.771 0.1178 0.8 11.58 13.063 0.5667 0.3 0.7 11.6 1.687 0.3593 0.7 8.74 13.98 0.1901 0.7 11.94 1.753 0.5868 0.4 0.6 11.71 1.668 0.3957 0.6 9.55 1.935 0.614 0.6 1.9 1.538 0.606 0.5 0.5 1.17 1.688 0.4309 0.5 10.37 1.691 0.3303 0.5 1.65 1.44 0.6138 0.6 0.4 1.6 1.749 0.4645 0.4 11.18 1.573 0.3959 0.4 13.01 1.414 0.604 0.7 0.3 13.08 1.849 0.4963 0.3 1.00 1.585 0.4570 0.3 13.37 1.507 0.68 0.8 0. 13.53 1.988 0.560 0. 1.81 1.76 0.5131 0. 13.73 1.70 0.613 0.9 0.1 13.99 13.164 0.5535 0.1 13.63 1.99 0.5640 0.1 14.08 1.993 0.6167 1.0 0.0 14.44 13.375 0.5787 0.0 14.44 13.375-0.044 0.0 14.44 13.375 0.6095 Mmum Varance Portfolo 0.44 1.87 1.405 0.4971.36 11.5 1.56 0.3835.65 11.71 1.668 0.3951 Fgure Effcent Fronter: 1991--000 15.0 14.0 100 S&P 13.0 56 S&P and 44 Europe 1.0 11.0 10.0 100 World 40 S&P and 60 World 64 S&P and 36 EAFE 100 Europe 9.0 8.0 7.0 100 EAFE 6.0 0.10 0.15 0.130 0.135 0.140 0.145 0.150 Rsk 004, Assocaton for Fancal Counselg and Planng Educaton. All rghts of reproducton any form reserved. 59

Fancal Counselg and Planng Volume 15 (1), 004 Table 5 and Rsk for Portfolos of Varous Combatons of S&P 500 wth Selected Indexes between MSCI World Index MSCI EAFE Index MSCI Europe Index S&P World Europe.Std. Sharpe.Std. Sharpe Std. Sharpe Dev Rato EAFE Dev Rato Dev Rato 0.0 1.0 10.49 14.57 0.3088 1.0 5.64 14.776-0.044 1.0 13.51 14.544 0.5161 0.1 0.9 11.03 14.61 0.3441 0.9 6.67 14.534 0.0459 0.9 13.75 14.69 0.549 0. 0.8 11.57 14.718 0.3785 0.8 7.69 14.380 0.1178 0.8 13.99 14.094 0.5667 0.3 0.7 1.11 14.845 0.4118 0.7 8.7 14.314 0.1901 0.7 14.3 14.01 0.5868 0.4 0.6 1.65 14.991 0.4439 0.6 9.75 14.338 0.614 0.6 14.47 14.05 0.606 0.5 0.5 13.0 15.158 0.4748 0.5 10.77 14.453 0.3303 0.5 14.71 14.187 0.6138 0.6 0.4 13.74 15.34 0.5045 0.4 11.80 14.656 0.3959 0.4 14.95 14.43 0.604 0.7 0.3 14.8 15.546 0.538 0.3 1.83 14.94 0.4570 0.3 15.19 14.754 0.68 0.8 0. 14.8 15.766 0.5597 0. 13.86 15.308 0.5131 0. 15.43 15.175 0.613 0.9 0.1 15.37 16.003 0.5853 0.1 14.88 15.749 0.5640 0.1 15.67 15.679 0.6167 1.0 0.0 15.91 16.57 0.6095 0.0 15.91 16.57 0.6095 0.0 15.91 16.57 0.6095 Mmum-Varance Portfolo.66 8.63 14.400 0.189.68 8.95 14.311 0.064.68 14.7 14.019 0.5903 Fgure 3 Effcent Fronter: 100 S&P 15.5 3 S&P and 68 Europe 13.5 100 Europe 11.5 100 World 9.5 3 S&P and 68 EAFE 7.5 100 EAFE 5.5 0.135 0.140 0.145 0.150 0.155 0.160 0.165 Rsk 60 004, Assocaton for Fancal Counselg and Planng Educaton. All rghts of reproducton any form reserved.

Does Internatonal Dversfcaton Pay? Portfolos for the last 10 years, 1991 to 000, are also evaluated. Table 4 and Fgure gve the performance for portfolos constructed wth the S&P 500 and the world, EAFE, and Europe dexes. For ths subperod, results wth the World dex are the same as those obtaed when the entre sample perod s used. The overall rsk of the portfolo can be reduced by dversfcaton, but terms of mean-varance, an vestor s advsed to avod the World dex, as evdenced by the Sharpe ratos. Fally, portfolo performance over the last fve years of the perod, 1996 to 000, are evaluated. Table 5 and Fgure 3 gve the portfolo performance and results for portfolos constructed wth the S&P 500 and the World, the EAFE, and the Europe dexes. When S&P 500 returns are combed wth EAFE returns over the last 10 years, the mmum-varance portfolo conssts of 64 the S&P 500 and 36 EAFE, the S&P 500 domates the EAFE, and aga the overall rsk can be reduced. But based on the Sharpe crtera, the return per unt rsk wll be maxmzed f an vestor avods the EAFE over the last 10 years. Ths result s dfferent when the entre sample perod s used when 10 EAFE s optmal. Ths result dcates that the benefts of ternatonal dversfcaton may have decreased the last 10 years the EAFE market. The S&P 500 domates the Europe dex; the effcent portfolo conssts of 68 or less Europe and 3 or more the S&P 500. The best resultsusg mean-varance crtera are acheved when 70 of the portfolo s vested the S&P 500 and 30 the European dex. The results from the last 10 years dcate that ternatonal dversfcaton stll provdes dversfcaton benefts and rsk reducton, but when the mean-varance crtera are used, the Sharpe rato s maxmzed when European markets are cluded the portfolo. One s better off vestg European markets, but not vestg the world or the EAFE dex. A general concluson can be made that dversfcaton benefts have decreased over the last 10 years. Fdgs for the most recent perod, the fve years of, are shown Table 5 and Fgure 3. There s no dversfcaton beneft to stock portfolos formed between the S&P 500 and the World Index because of the hgh correlaton between the two dexes over the perod. The effcent fronter s almost a straght le. The Sharpe rato s maxmzed when 100 of the portfolo s vested the S&P 500, dcatg that, the most recent perod, evaluated, dversfcaton benefts from the world dex have completely dsappeared. When S&P 500 returns are combed wth EAFE returns over the last fve years, S&P 500 domates the EAFE and, aga, the overall rsk can be reduced. But based on the Sharpe crtera, the return per unt rsk wll be maxmzed f an vestor stays away from the EAFE. The dea that benefts of ternatonal dversfcaton have decreased over the years s once aga reforced by these results. Overall rsk can be reduced when the S&P 500 and the Europe dex are combed. The best results usg mean-varance crtera are acheved when 80 of the portfolo s vested the S&P 500 and 0 the European dex. The results from the last fve years dcate that returns per unt rsk are creased only when dversfyg European markets and that the dversfcaton benefts have decreased over the last 10 years. Summary and Conclusons Ths paper exames the benefts of dversfcaton acheved by vestg ternatonal markets. Monthly returns for four dfferent dexes the S&P 500; Morgan Stanley Captal Internatonal (MSCI) World Index; Europe, Australa, and Far East (EAFE) Index; and the MSCI Europe Index - over a perod of years, from 1978 to 000, are analyzed. In addton, portfolos of domestc and ternatonal dexes are created to determe whether ternatonal dversfcaton would crease portfolo performance. Effcent fronters are drawn and mmum-varance portfolos are determed. Furthermore, portfolo returns for the last 10 years of the perod, 1991 to 000, and the last fve years, 1996 to 000, are also analyzed. Ths s done to test the popular contenton that the benefts of ternatonal dversfcaton are steadly decreasg. The meanvarance framework and Sharpe measure are also used to determe whch dex or portfolo has the hghest reward-to-varablty rato. Our maor fdg s that the benefts of ternatonal dversfcaton are stll present, but are decreasg wth tme. When the whole perod s used, portfolos wth the S&P 500 and all three ternatonal dexes, the overall rsk s reduced. The Sharpe rato shows that an vestor benefts from vestg a part of the portfolo the EAFE and Europe markets, but not the world markets. Ths result s mportant, as dvdually the S&P 500 domates both the EAFE and the Europe dexes. Results from the perod s last 10 years, as well as from the last fve years, dcate that the benefts of ternatonal dversfcaton are dmshg and that the correlatons between the world markets are 004, Assocaton for Fancal Counselg and Planng Educaton. All rghts of reproducton any form reserved. 61

Fancal Counselg and Planng Volume 15 (1), 004 creasg. The reward-to-rsk rato creases only when an vestor dversfes the Europe dex. In the last fve years, the effcent fronter between the S&P 500 and world dex s a straght le, showg that the world markets were very hghly correlated wth the U.S. markets. Nevertheless, rsk s reduced when the EAFE and Europe dexes are used wth the S&P 500, and vestors should stll have a part of ther portfolos vested ternatonal markets. References Aello, S., & Cheffe, N. (1999). Internatonal dex funds and the vestment portfolo. Fancal Servces Revew, 8 (1), 7-35. Baley, W., & Stulz, R. (1990, Summer). Measurg the benefts of ternatonal dversfcaton wth daly data: The case of Pacfc Bas stock markets. Journal of Portfolo Management, 57-61. Barry, B. C., Peavy, J. W., & Rodrguez, M. (1997). Emergg stock markets: Rsk, return, and performance. Charlottesvlle, VA: The Research Foundaton of the Insttute of Chartered Fancal Analysts. Bekaert, G., & Uras, M. S. (1996). Dversfcaton tegraton and emergg market closed-end funds. Journal of Fance, 51, 835-870. Butler, K. C., Domgo, J. & Domgo, C. (1998). A note on poltcal rsk and the requred return on foregn drect vestment. Journal of Internatonal Busess Studes, 9, 599-607. Chernoff, J. (00, January 7). Good and Bad News: Internatonal funds may not decrease rsk after all. Pensons and Investments, 30(1), 1-. De Roon, F. A., Nman, T. E., & Werker, B. J. M. (001). Testg for mean varance spanng wth short sales constrats and transacton costs: The case of emergg markets. Journal of Fance, 56, 71-74. Dwan, I., Errunza, V., & Senbet, L. (1994). Dversfcaton benefts of country funds. In M. Howell (Ed.), Investg Emergg Markets (pp.199-18). London: Euromoney. Dressen, J., & Laeven, L. (003). Internatonal portfolo dversfcaton benefts: Cross-country evdence. In J. Hanson, P. Honohan, & G. Manon (Eds.), Globalzaton and Natonal Fancal Systems (pp. 175-188). Washgton, DC: World Bank. Eftekhar, B., & Satchell, S. E. (1999). Internatonal vestors exposure to rsk emergg markets. Journal of Fancal Research, (1), 84-89. Errunza, V. R. (1977). Gas from portfolo dversfcaton to less developed countres securtes. Journal of Internatonal Busess Studes, 8(), 83-99. Errunza, V. R. (1994). Emergg markets: Some new concepts. Journal of Portfolo Management, 0(3), 8-87. Grold, R., Rudd, A. & Stefek, D. (1989). Global factors: Fact or fcton? Journal of Portfolo Management, 16, 79-88. Hanna, M. E., McCormack, J. P. & Perdue, G. (1999). A netes perspectve on Internatonal dversfcaton. Fancal Servces Revew, 8(1) 37-45. Harvey, C. R.(1993). Portfolo enhancement usg emergg markets and condtong formaton. In S. Claessens & S. Gooptu (Eds.), Portfolo Investment Developg Countres (pp. 110-144). Washgton, DC: World Bank. Harvey, C. R.(1995). Predctable rsk and returns emergg markets. Revew of Fancal Studes, 8, 773-816. Ho, K., Mlevsky, M. A., & Robson, C. (1999). Internatonal equty dversfcaton and shortfall rsk. Fancal Servces Revew, 8(1), 11-5. Huberman, G., & Kandel, S. A. (1987). Mean varance spanng. Journal of Fance, 4, 383-388. Iyer, B. S. (1998, December). The case for Internatonal dversfcaton. Employee Beneft Journal, 3, 17-18. Kohers, T., Kohers, G., & Pandey, V. (1998). The contrbuton of emergg markets Internatonal dversfcaton strateges. Appled Fancal Economcs, 8, 445-454. Lessard, D. (1990). Beyond the debt crss: Alternate forms of fancg growth. In I. Husa & I. Dwan (Eds.), Dealg wth Debt Crss, Washgton, DC: World Bank Press. Levy, H., & Sarnat, M. (1970). Internatonal dversfcaton of vestment portfolos. Amercan Economc Revew, 60, 668-675. Lofthouse, S. (1997). Internatonal dversfcaton. Journal of Portfolo Management, 53(1) 53-56. Olenyk, J. P., Schwebach, R. G., & Zumwalt, J. K. (00). The mpact of fancal crses on Internatonal dversfcaton. Global Fance Journal, 13(), 147-161. Shapro, A. C. (1996). Multatonal Fancal Management. Upper Saddle Rver, NJ: Prentce Hall Sh H. H., & Sonen, L. (1999). Exposure to currency rsk by U.S. multatonal corporatons. Journal of Multatonal Fancal Management, 9, 195-07. Zervos, S. J. (1996). Industry and country components emergg market stock returns. (Center of Emprcal Research Fance Dscusson Paper 96-0). Mddlesex, England: Brunel Unversty. 6 004, Assocaton for Fancal Counselg and Planng Educaton. All rghts of reproducton any form reserved.