International Diversification: Is It Worth It?

1. Sanford C. Bernstein & Co., LLC Controversies in Quantitative Finance and Asset Management | 2005 March 1, 2005 Pierre Hotel, New York International Diversification: Is It Worth It? Claude B. Erb Campbell R. Harvey Tadas E. Viskanta TCW, Duke University, Independent, Los Angeles, CA USA Durham, NC USA Chicago, IL USA NBER, Cambridge, MA USA

3. Targeting The “Risk” of the MSCI World IndexDecember 1969 to January 2005 • The “optimal” portfolio is largely “foreign”

4. Targeting The “Risk” of the MSCI World IndexDecember 1987 to January 2005 • The “optimal” portfolio is largely domestic

5. Targeting The “Risk” Of The MSCI U.S. IndexDecember 1969 to January 2005 • The “optimal” portfolio has little U.S. exposure

6. Targeting The “Risk” Of The MSCI U.S. IndexDecember 1987 to January 2005 • The “optimal” portfolio has little “foreign” exposure

7. International Diversification – Is It Worth It? Interesting question but … what question is being asked? • It is possible to parse this into at least four questions • Does passive investment outside of your home market increase return? • Does active investment outside of your home market increase return? • Does passive investment outside of your home market reduce risk? • Does active investment outside of your home market reduce risk? • Let’s take a look at some answers

8. US Domestic Versus Foreign PerspectiveGrowth of $1December 1969 to January 2005 • A U.S. investor might look at historical performance and wonder • Why invest in non-US equities? Data Source: Morgan Stanley Capital International

9. The Allure Of Tactical AllocationU.S. Domestic/Foreign Tactical Asset AllocationDecember 1969 to January 2005 • A declining “domestic/foreign” tracking error suggests a reduced opportunity to add value from tactical allocation • Excess Return = Excess Return Ratio * Tracking Error Data Source: Morgan Stanley Capital International

10. European Domestic Versus Foreign PerspectiveGrowth of $1December 1969 to January 2005 • A European investor might look at historical performance and wonder • Why invest in non-European equities? Data Source: Morgan Stanley Capital International

11. The Allure Of Tactical AllocationEuropean Domestic/Foreign Tactical Asset AllocationDecember 1969 to January 2005 • A declining “domestic/foreign” tracking error suggests a reduced opportunity to add value from tactical allocation Data Source: Morgan Stanley Capital International

12. U.K. Domestic Versus Foreign PerspectiveGrowth of $1December 1969 to January 2005 • A U.K. investor might look at historical performance and wonder • Why invest in non-UK equities? Data Source: Morgan Stanley Capital International

13. The Allure Of Tactical AllocationU.K. Domestic/Foreign Tactical Asset AllocationDecember 1969 to January 2005 • A declining “domestic/foreign” tracking error suggests a reduced opportunity to add value from tactical allocation Data Source: Morgan Stanley Capital International

14. Japanese Versus Foreign PerspectiveGrowth of $1December 1969 to January 2005 • Even a Japanese investor might look at historical performance and wonder • Why invest in non-Japanese equities? Data Source: Morgan Stanley Capital International

15. The Allure Of Tactical AllocationJapanese Domestic/Foreign Tactical Asset AllocationDecember 1969 to January 2005 • A stable “domestic/foreign” tracking error suggests an unchanged opportunity to add value from tactical allocation Data Source: Morgan Stanley Capital International

16. Maybe Sectors More Important Than Countries?

17. The Minimum Variance Portfolio Over Time Rolling 12-month optimization.

18. Rolling Ten Year Total ReturnsDecember 1969 to January 2005 Data Source: Morgan Stanley Capital International

19. Does passive investment outside of your home market reduce risk?Rolling Ten Year Standard Deviations Of Return ReturnsDecember 1969 to January 2005 Data Source: Morgan Stanley Capital International

20. Does passive investment outside of your home market reduce risk?Rolling Ten Year Sharpe RatiosDecember 1969 to January 2005 Data Source: Morgan Stanley Capital International

21. International Diversification – Is It Worth It? While the U.S. is a smaller part of world market capitalization, correlations are high. • We consider some alternative ways of considering correlation • Average returns based on U.S. up and down markets • Average returns based on quintiles of U.S. returns • Average returns in U.S. business cycle phases

22. Effect of US Equity Returns on Global Equity ReturnsJanuary 1970 to December 2004 Data: Annualized MSCI Monthly Returns in excess of one month T-bill.

23. Effect of US Equity Returns on Global Equity Returns Developed Markets:January 1988 to December 2004 Data: Annualized MSCI Monthly Returns in excess of one month T-bill.

24. Effect of US Equity Returns on Global Equity Returns Emerging Markets:January 1988 to December 2004 Data: Annualized MSCI Monthly Returns in excess of one month T-bill.

25. Effect of US Equity Returns on Global Equity ReturnsJanuary 1970 to December 2004 Data: MSCI Monthly Returns in excess of one month T-bill. January 1970-December 2004.

26. Effect of US Equity Returns on Global Equity Returns Developed Markets: January 1988 to December 2004 Data: Annualized MSCI Monthly Returns in excess of one month T-bill.

27. Effect of US Equity Returns on Global Equity Returns Emerging Markets:January 1988 to December 2004 Data: Annualized MSCI Monthly Returns in excess of one month T-bill.

28. Effect of US Economic Phase on Global Equity ReturnsJanuary 1970 to December 2004 Data: Annualized MSCI Monthly Returns in excess of one month T-bill. NBER dating.

29. Effect of US Economic Phase on Global Equity Returns Developed Markets: January 1988 to December 2004 Data: Annualized MSCI Monthly Returns in excess of one month T-bill. NBER dating.

30. Effect of US Economic Phase on Global Equity Returns Emerging Markets:January 1988 to December 2004 Data: Annualized MSCI Monthly Returns in excess of one month T-bill. NBER dating.

31. International Diversification – Is It Worth It? But we know that the business cycle is to some degree predictable. • U.S. yield curve predicts business cycle phases • Average returns based on U.S. inverted or normal yield curve • Average returns based on shape of yield curve

32. Yield Curve Inverts Before Last Six Recessions(5-year Treasury note minus 3-month Treasury bill yield) Annual GDP growth or Yield Curve % % Real annual GDP growth Yield curve Recession Correct Recession Correct Yield curve accurate in recent forecast Recession Correct 2 Recessions Correct Data though January 2005 Source: Campbell R. Harvey. Update of Harvey (1986, 1988, 1989).

33. Effect of US Yield Curve on Global Equity ReturnsJanuary 1970 to December 2004 Data: Annualized MSCI Monthly Returns in excess of one month T-bill. Yield Curve=10 Year-3 Month Treasuries, one month lagged.

34. Effect of US Yield Curve on Global Equity Returns Emerging Markets:January 1988 to December 2004 Data: Annualized MSCI Monthly Returns in excess of one month T-bill. Yield Curve=10 Year-3 Month Treasuries, one month lagged

35. Effect of US Yield Curve on Global Equity ReturnsJanuary 1970 to December 2004 Data: Annualized MSCI Monthly Returns in excess of one month T-bill. Yield Curve=10 Year-3 Month Treasuries, one month lagged

36. International Diversification – Is It Worth It? Conclusions • For a U.S. investor, the strategic case for international diversification has been oversold • While tactical opportunities are diminishing through time, there is still plenty of opportunity to enhance portfolio returns by active management using international equities.