The Declining Gain from International Portfolio Diversification

The attainable diversification from participating in foreign markets is declining, whether the investor holds foreign stocks inside or outside the United States.

One of the most enduring puzzles in international macroeconomics and finance is the tendency for investors to disproportionately weight their asset portfolios towards domestic securities and thus to forego the gains possible through international diversification. This tendency causes consumers to be underinsured against aggregate shocks that otherwise could have been hedged by holding foreign assets. In the framework of both macroeconomics and financial economics, the underlying source of diversification arises from the relatively low correlation in asset returns across countries.

In Is the International Diversification Potential Diminishing? Foreign Equity Inside and Outside the U.S. (NBER Working Paper No. 12697), author Karen Lewis examines the data on foreign returns from a U.S. investor's point of view to consider the impact of changing co-variances among international returns on the opportunities for diversification. She first analyzes foreign markets to consider the typical argument that domestic residents hold a less-than-optimal low portfolio allocation in foreign stock indexes.

Lewis finds that the co-variances among country stock markets have indeed shifted over time for a majority of countries. However, in contrast to the common perception that markets have become more integrated over time, the co-variance between foreign markets and the U.S. market has increased only slightly over the last twenty years. Moreover, the standard deviation of the foreign portfolio has declined over this time.

To consider the economic significance of these changes, Lewis looks at a simple portfolio decision model in which a U.S. investor could choose between U.S. and foreign market portfolios. With two different assumptions about the estimates of foreign means, she finds that the optimal allocation in foreign markets actually has increased over time. This appears counter-intuitive, given that the higher degree of integration among countries increases the correlation across markets. On the other hand, the falling variance of foreign portfolios increases the allocation of assets into foreign markets.

Lewis then looks at whether foreign stocks that list in the United States can explain the lack of foreign investment. She finds, somewhat surprisingly, that the estimates of co-variation with the U.S. market have increased over time. Also, while the allocations in foreign markets do not decline much over time, the allocation into U.S. listed foreign stocks does decline, particularly in the 1990s. These results suggest that the diversification properties of domestic-listed foreign stocks are inferior to investing directly in foreign markets.

Using a two-asset model with cross-listed foreign stocks instead of foreign market indexes, Lewis finds that the greatest gains in diversification improvement since 1994 have been in foreign market indexes, rather than foreign cross-listed stocks or a combination of both groups.

Finally, she points out that her analysis is simply a way to demonstrate the effects of the parameters. An unconstrained, efficient portfolio decision based upon the universe of foreign stocks undoubtedly would allow a larger reduction in risk. Nevertheless, her analysis points to some general trends in the foreign portfolio diversification potentials. These trends could be summarized as follows: first, international equity markets have become more highly correlated. Second, foreign stocks inside the United States have become more correlated with the U.S. market over time. As a consequence of these trends, the attainable diversification from participating in foreign markets is declining, whether the investor holds foreign stocks inside or outside the United States.

-- Les Picker