Global Portfolio Diversification. Global Portfolio Diversification. Global Portfolio Diversification

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1 Global Portfolio Diversification Global Portfolio Diversification For Long- Horizon Investors The case for global portfolio diversification in equities is still very strong for long-horizon investors, despite the secular and cyclical increase in the correlation of returns across markets. Luis M. Viceira, Harvard Business School (Joint research with Kevin Wang and John Zhou, Harvard) Asset Management in 27: Pioneers and New Frontiers Robert H. Smith School of Business Center For Financial Policy and UBS New York, Wednesday May 24, 27 Why? Because Long-horizon equity correlations have not increased as much as short-horizon correlations The main driver of the increase in short-run correlations has been the integration of global capital markets, which makes investor sentiment (or risk aversion) more correlated across markets. This drives short run correlations up, but not long-run correlations, because investor sentiment has only a transitory impact on valuations. Global Portfolio Diversification Global Portfolio Diversification The case for global portfolio diversification in bonds is weaker today. For bond markets, both short- and long-run return correlations have gone up: Inflation is now much more correlated across currency areas, which drives long-run bond return correlations up. This is good news however for ALM, as global bonds are today better instruments to hedge local liabilities. Triumph of the principle of portfolio diversification: Enormous growth in index investing and investment vehicles that emphasize portfolio diversification (Viceira 25, 26). However, preponderance of home bias when it comes to global diversification (Vanguard 24): While US equities accounted for 5% of global equity market capitalization on December 23, U.S. mutual fund investors held, on average, only 27% of their total equity allocation in non-u.s. equity funds. Most U.S. balanced and life-cycle funds offered in the U.S. have an allocation to non-u.s. equities well below their share of global equity market capitalization.

2 Global Portfolio Diversification The benefits of international portfolio diversification across equity markets have been well documented. Historically, cross-country correlations of equity markets are time varying but on average they have been far from perfect: French and Poterba (99), Odier and Solnik (993), Erb et al. (994), Erb et al. (995), Longin and Solnik (995), Karolyi and Stulz (996), De Santis and Gerard (997), Bekaert et al. (998), Campbell, Serfaty-de-Medeiros and Viceira (2), Vanguard (24). Diversification benefits come from country factors, not only industry factors: Heston and Rouwenhorst (994), Campa and Fernandes (26) Investors must have implausibly large return expectations on their own markets to justify holding home biased portfolios (French and Poterba 99) Global Portfolio Diversification Evidence that cross-country correlations increase in falling markets at short horizons (asymmetric correlations, negative co-skewness): Ang and Bekaert (2), Longin and Solnik (2), Hartmann et al. (24), Chua et al. (29), Asness et al. (2) But not enough to eliminate the gains from international portfolio diversification and no evidence of negative skewness at longer horizons: De Santis and Gerard (997), Leibovitz and Bova (29), Asness et al. (2) Local portfolios focused on global companies do not produce the same gains as globally diversified equity portfolios, especially when including medium and small cap stocks: Errunza et al. (999), Cheol et al. (28) Global Portfolio Diversification Table 3: Cross-Country Return Correlations The benefits of international portfolio diversification across bond markets are much less well documented but they can be potentially large too: Within Countries (Average) Across Countries The cross-country correlations of currency-hedged returns on long-term bonds are even lower than those of equity markets (Campbell, Serfaty-de- Medeiros, and Viceira, 2) Bonds Stocks Bonds Stocks Bonds. Bonds.52 Stocks.7. Stocks.3.62 Average bond-stock correlations across countries and within countries. Sample period: Countries: Australia, Canada, France, Germany, Japan, United Kingdom, and United States. Returns are in U.S. Dollar currency-hedged terms in excess of the one-month U.S. Treasury bill rate. 2

3 Global Portfolio Diversification Table 3: Cross-Country Return Correlations However, cross-country correlations of equity and bond markets have experienced a secular increase since at least the turn of the century. Within Countries (Average) Across Countries Christoffersen et al. (22): The benefits of holding global equity portfolios has declined Bonds Stocks Bonds Stocks Bonds. Bonds.52 Stocks.7. Stocks Bonds Stocks Bonds Stocks Bonds. Bonds.44 Stocks.3. Stocks Bonds Stocks Bonds Stocks Bonds. Bonds.65 Stocks.23. Stocks Figure : Cross-Country Return Correlations Figure 2: Cross-Asset Return Correlations.6.4 Bond-Stock Within Countries Bond-Stock Across Countries.2 Correlation Date Average correlations of bond returns across countries and stock returns across countries. Monthly averages are computed using pairwise 3-year return correlations across seven different countries (Australia, Canada, France, Germany, Japan, United Kingdom, and United States). Returns are in U.S. Dollar currency-hedged terms in excess of the one-month U.S. Treasury bill rate. Average bond-stock correlations across countries and within countries. Monthly averages are computed using pairwise 3-year return correlations within and across seven different countries (Australia, Canada, France, Germany, Japan, United Kingdom, and United States). Returns are in U.S. Dollar currency-hedged terms in excess of the one-month U.S. Treasury bill rate. 3

4 Global Portfolio Diversification Sources of Variation in Returns Does this secular increase in cross-country return correlations mean that the benefits of global portfolio diversification have declined? For short-term long-only investors, yes But not necessarily for long-term investors: it all depends on the source of the increase in return correlations. Therefore, the price and return on an asset can vary over time for two reasons (Campbell and Shiller 988, Campbell 99): In response to news about fundamentals or changes in expectations of future cash flows (cash flow news). In response to news about the rate at which investors discount those cash flows (discount rate news). Return Decomposition Sources of Cross-Country Correlations of Returns Empirically, Cash flow news tend to have a permanent effect on asset valuations. Discount rate news tend to have a transitory effect on asset valuations: Source of mean-reversion in asset returns Risk aversion (or investor sentiment) tends to be countercyclical According to this logic, the increase in cross-country return correlations in recent years must be the result of an increase in cross-country correlations of cash flows or fundamentals (globalization of trade flows) an increase in cross-country correlations of discount rates (capital markets integration) or a combination of the two (Ammer and Mei, 996) 4

5 Capital Markets Integration Capital markets integration means that long-run return correlations do not necessarily increase as much as short-run return correlations. Arguably international stock and bond markets are less segmented today than before, and investor sentiment and risk aversion tend to move together. In the case of full integration, the marginal investor pricing equities and bonds in every market is the same across all markets. Sources of Cross-Country Correlations of Returns Why does the source of increased global correlations matter? Both sources of variation in returns have the same effect on cross-country return correlations of short horizons. But they have a differential effect on long-run cross-country return correlations: Increases in correlations of persistent cash flow news increase return correlations equally across all horizons and reduce the benefits of global diversification at all horizons. Increases in correlations of transitory discount rate news have a smaller effect on long-horizon return correlations and do not necessarily imply a reduction in the benefits of global diversification at long horizons. At short horizons, portfolio risk increase is the same regardless of source of increased correlations Illustrative Example Figure 4. Portfolio Risk Across Investment Horizons At long horizons, increased corrrelation of fundamentals across markets has a much larger impact on portfolio risk than increased correlation of discount rates (or investor sentiment) Symmetric Model of Global Capital Markets The scope for global portfolio diversification for long horizon investors does not decline as much when capital market integration is the source of increased cross-country return correlations than when real integration is the source. At long horizons, the increase in overall portfolio risk is significantly smaller Long-term investors can still use global portfolios to diversify away longterm cash flow risk, because only transitory shocks to returns and valuations become more correlated. 5

6 Table. Summary Statistics (986-23) Table. Summary Statistics: Stocks Bonds Mean 5.8% 3.9% 3.9% 2.5%.7% 4.4% 3.6% Volatility 6.8% 6.3% 5.6% 5.2% 5.5% 6.5% 6.4% Sharpe Ratio Stocks Mean 5.8% 3.8% 4.% 2.4% 2.% 5.2% 5.9% Volatility 7.7% 5.8% 2.% 22.2% 2.4% 6.% 5.7% Sharpe Ratio Stocks ( ) Mean 6.% 4.2% 9.% 4.3%.3% 8.7%.5% Volatility 2.2% 5.5% 2.% 2.5% 2.9% 7.4% 5.3% Sharpe Ratio Stocks (2 23) Mean 5.5% 3.5%.%.5% 2.7%.6%.3% Volatility 3.6% 6.% 8.7% 23.% 8.8% 4.7% 6.% Sharpe Ratio Table. Summary Statistics: Bonds Table 4-5. Return Correlation Decomposition Bonds ( ) Mean 7.% 4.2% 4.3%.6%.6% 5.2% 3.2% Volatility 7.6% 7.% 5.9% 5.2% 6.8% 7.5% 6.4% Sharpe Ratio Bonds (2 23) Mean 4.5% 3.7% 3.6% 3.4%.% 3.5% 4.% Volatility 5.9% 5.2% 5.3% 5.3% 3.8% 5.4% 6.5% Sharpe Ratio Stocks Across Countries Component Correlations CF (s) RR (s) ER (s) CF (s).2 RR (s).5.33 ER (s) CF (s).24 RR (s).3.59 ER (s) Difference CF (s).4 RR (s).8.26 ER (s) CF (s) RR (s) ER (s) p values CF (s).8 (bootstrap) RR (s).. ER (s)... p values CF (s).34 (Fisher r to z) RR (s).5. ER (s).26.. Bonds Across Countries Component Correlations CF (b) RR (b) ER (b) CF (b).29 RR (b).3.3 ER (b).3..2 CF (b).5 RR (b) ER (b) CF (b).2 RR (b) ER (b) CF (b) RR (b) ER (b) CF (b). RR (b).. ER (b).3.. CF (b). RR (b).. ER (b) CF = cash flow news; RR = news about interest rates; ER = news about risk premia 6

7 Figure 6. Stock Portfolio Risk Components.8 Average Cross-Country Correlation Average Within-Country Standard Deviation Figure 6. Stock Portfolio Risk (Annualized Standard Deviation of Value-Weighted Portfolio) Figure 7. Stock Portfolio Risk (Holding Within-Country Volatility Constant) std_global_early (stock) std_global_late (stock) ave_corr_early ave_corr_late ave_std_early ave_std_late Figure 8. Bond Portfolio Risk (Annualized Standard Deviation of Value-Weighted Portfolio)

8 Figure 8. Bond Portfolio Risk Components Average Cross-Country Correlation Average Country Standard Deviation Conclusions Short-run cross-country return correlations have increased substantially in the 2 st century, both for equities and bonds. For equities, this increment has been driven primarily by integration of capital markets: the marginal investor in global markets today is the same and investors risk aversion (or sentiment) is more correlated across markets There is much less evidence that globalization of trading flows has led to an increment in cross-country stock return correlations. Because the impact of changes in risk aversion or investor sentiment on valuations is transitory, long-run cross-country stock return correlations have not increased nearly as much. Conclusions Conclusions The benefits of international equity portfolio diversification have not declined nearly as much for long-horizon investors than for short-horizon investors. The empirical evidence suggests that globalization of capital markets has not lead to a significant increase in the long-run risk of globally diversified equity portfolios. Long-term investors can still use global portfolios to diversify away long-term equity cash flow risk. For bonds, this increment has been driven by both integration of capital markets and increased correlation of inflation across monetary areas. Long-run cross-country bond return correlations have increased as much as short-run correlations. The benefits of international bond portfolio diversification have declined as much for long-horizon long-only bond investors as for short-horizon investors. However, investors with long-dated liabilities can benefit from this increase in global bond correlations: the scope of hedging liabilities using global bonds has increased. Lastly, the benefits of stock-bond diversification have increased in all developed markets. 8