International Diversification with Factor Funds

We propose a new investment strategy employing “factor funds” to systematically enhance the mean-variance efficiency of international diversification. Our approach is motivated by the increasing evidence that size (SMB), book-to-market (HML), and momentum (MOM) factors, along with the market factor, adequately describe international stock returns, and by the direct link between investors' portfolio choice problems and international asset pricing theories and tests. Using data from 10 developed countries during the period 1981--2008, we show that the “augmented” optimal portfolio involving local factor funds substantially outperforms the “benchmark” optimal portfolio comprising country market indices only as measured by their portfolio Sharpe ratios. This strongly rejects the intersection hypothesis which posits that the local factor funds do not span investment opportunities beyond what country market indices do. Among the three classes of factor funds, HML funds contribute most to the efficiency gains. In addition, the local version of factor funds outperforms the global factor funds. The added gains from local factor diversification are significant for both in-sample and out-of-sample periods, and for a realistic range of additional investment costs for factor funds, and remain robust over time.

[1]  C. Gouriéroux,et al.  Likelihood Ratio Test, Wald Test, and Kuhn-Tucker Test in Linear Models with Inequality Constraints on the Regression Parameters , 1982 .

[2]  Francesca Carrieri,et al.  Industry Risk and Market Integration , 2003, Manag. Sci..

[3]  Stefan Nagel,et al.  A Skeptical Appraisal of Asset-Pricing Tests , 2006 .

[4]  Geert Bekaert,et al.  International Stock Return Comovements , 2005 .

[5]  Sean P. Baca,et al.  The Rise of Sector Effects in Major Equity Markets , 2000 .

[6]  Erzo G. J. Luttmer.  Asset pricing in economies with frictions , 1996 .

[7]  J. Jobson,et al.  A Performance Interpretation of Multivariate Tests of Asset Set Intersection, Spanning, and Mean-Variance Efficiency , 1989, Journal of Financial and Quantitative Analysis.

[8]  H. Levy,et al.  International Diversification of Investment Portfolios , 1970 .

[9]  Sheridan Titman,et al.  On Persistence in Mutual Fund Performance , 1997 .

[10]  Owen A. Lamont.  Economic Tracking Portfolios , 1999 .

[11]  F. D. Roon,et al.  Testing for Mean-Variance Spanning with Short Sales Constraints and Transaction Costs: The Case of Emerging Markets , 2001 .

[12]  Gur Huberman,et al.  Mean-Variance Spanning , 1987 .

[13]  Bruce G. Resnick,et al.  Exchange Rate Uncertainty, Forward Contracts, and International Portfolio Selection , 1988 .

[14]  John M. Griffin,et al.  Are the Fama and French Factors Global or Country-Specific? , 2002 .

[15]  Warren Bailey,et al.  Foreign Investments of U.S. Individual Investors: Causes and Consequences , 2008, Manag. Sci..

[16]  S. Ross.  The arbitrage theory of capital asset pricing , 1976 .

[17]  Bruno Gerard,et al.  International Diversification in the Euro-Zone: The Increasing Riskiness of Industry Portfolios - Appendix Containing Auxiliary Results , 2005 .

[18]  Richard Roll,et al.  Industrial Structure and the Comparative Behavior of International Stock Market Indices , 1992 .

[19]  William N. Goetzmann,et al.  Long-Term Global Market Correlations , 2001 .

[20]  William N. Goetzmann,et al.  Portfolio Performance Manipulation and Manipulation-Proof Performance Measures , 2004 .

[21]  Kent D. Daniel,et al.  NBER WORKING PAPER SERIES EVIDENCE ON THE CHARACTERISTICS OF CROSS SECTIONAL VARIATION IN STOCK RETURNS , 1996 .

[22]  Campbell R. Harvey,et al.  PREDICTABLE RISK AND RETURNS IN EMERGING MARKETS , 1999 .

[23]  E. Fama,et al.  Common risk factors in the returns on stocks and bonds , 1993 .

[24]  Victor DeMiguel,et al.  Optimal Versus Naive Diversification: How Inefficient is the 1/N Portfolio Strategy? , 2009 .

[25]  Bruno Solnik,et al.  Dispersion as Cross-Sectional Correlation , 2000 .

[26]  T. Nijman,et al.  Testing for mean-variance spanning: a survey , 2001 .

[27]  Jim Kyung-Soo Liew,et al.  Can Book-to-Market, Size, and Momentum Be Risk Factors that Predict Economic Growth? , 1999 .

[28]  F. Longin,et al.  Is the Correlation in International Equity Returns Constant: 1960-90? , 1995 .

[29]  E. Fama,et al.  Value Versus Growth: The International Evidence , 1997 .

[30]  H. Grubel.  Internationally Diversified Portfolios: Welfare Gains and Capital Flows , 1968 .

[31]  Michael J. Aked,et al.  The Increasing Importance of Industry Factors , 2000 .

[32]  Franz C. Palm,et al.  Wald Criteria for Jointly Testing Equality and Inequality , 1986 .

[33]  Kewei Hou,et al.  What Factors Drive Global Stock Returns? , 2011 .

[34]  R. C. Merton,et al.  AN INTERTEMPORAL CAPITAL ASSET PRICING MODEL , 1973 .

[35]  Pierre Hillion,et al.  International Portfolio Diversification: Currency, Industry and Country Effects Revisited , 2009 .

[36]  Wei Huang,et al.  International Diversification with Large- and Small-Cap Stocks , 2008 .

[37]  Josef Lakonishok,et al.  Contrarian Investment, Extrapolation, and Risk , 1993 .

[38]  E. Fama,et al.  Multifactor Explanations of Asset Pricing Anomalies , 1996 .

[39]  G. Karolyi,et al.  Another Look at the Role of the Industrial Structure of Markets for International Diversification Strategies , 1996 .

[40]  John M. Griffin,et al.  Momentum Investing and Business Cycle Risk: Evidence from Pole to Pole , 2001 .

[41]  Guofu Zhou,et al.  Tests of Mean-Variance Spanning , 2008 .

[42]  René M. Stulz,et al.  On the Effects of Barriers to International Investment , 1981 .

[43]  Marco Del Negro,et al.  Country versus Region Effects in International Stock Returns , 2004 .

[44]  Bruno H. Solnik,et al.  An equilibrium model of the international capital market , 1974 .

[45]  Ralitsa Petkova.  Do the Fama-French Factors Proxy for Innovations in Predictive Variables? , 2005 .

[46]  Currency hedging for international stock portfolios: The usefulness of mean-variance analysis , 2003 .

[47]  K. Geert Rouwenhorst,et al.  Does industrial structure explain the benefits of international diversification , 1994 .