International Diversification and Labor Income Risk

1. International Diversification and Labor Income Risk Giovanna Nicodano (jointly with Carolina Fugazza and Maela Giofrè) Collegio Carlo Alberto-CeRP / University of Turin Presented at the Joint Discussion Forum hosted by ICPM / Netspar / Maastricht University October 2007 Rotman ICPM / Netspar / Maastricht University Discussion Forum – October 2007

2. Motivation • Standard portfolio management practices based on mean variance analysis account for financial risk and overlook investors’ labor income risk • Efficient portfolio is the market portfolio • Should they instead account also for labor income risk (LIR)?

3. MotivationHedging LIR? • “two-thirds of national product goes to labor, so human wealth is likely to be about two-thirds of total wealth and twice financial wealth... the omission of human wealth may be a serious matter “ • Campbell, 1996 • Labor income risk in portfolio choice models • mkt portfolio no longer efficient • optimal portfolio contains a LIR-hedging component, positive if return increases when wage growth falls • Mayers, 1972, Bodie et al. 1992, Viceira, 2001

4. MotivationHedging LIR in practice? • Would actual portfolio shares be really different from the standard ones? • Which assets should we consider? • First step: international equity diversification • Which labor income risk should we focus on? Individual Cocco Gomes Maenhout 2005 Industry ? National Coen 2001

5. MotivationIndustry– specific LIR • inter-industry wage differentialsare large and persist • US: Dickens and Katz, 1987; Krueger and Summers, 1987-88; Weinberg, 2004 • OECD: Gittleman and Wolff, 1993; Kahn, 1998 • wage shocks at industry and national leveldisplay different cyclical pattern • Blanchard and Fisher, 1989; Solon, Barsky and Parker, 1992

6. MotivationIndustry–specific LIR Correlations between industry and national wage growth (98-04)

7. MotivationIndustry-specific LIR • CAPM with labor income risk improves Jagannathan and Wang 1996 • R2 = 29.32% no LIR • R2 = 55.21% with national LIR • Larger improvement with industry-specific labor income risk - Eiling 2006 • R2 = 62% no LIR • R2 = 64% with national LIR • R2 = 75% with industry LIR

8. MotivationIndustry-specific LIR • Occupational pension funds • membership based on employment industry • members face the same industry shocks • Results shed light on whether pension funds should design portfolios to hedge labor income risk of their members • Caveat: classification of industry here does not with pension fund occupation; short sales allowed

9. and inflation Goal • Assess to what extent LIR would affect international equity diversification • Compute and compare equilibrium portfolios • no hedging of LIR • market shares • hedging LIRfor the representative national worker • restricted national portfolio • hedging LIR for the representative industry worker in each country • industry portfolios for each investing country • unrestricted national portfolio for each investing country

10. WAGES • US - Current Employment Statistics • Canada - Survey of Employment Payrolls and Hours • Italy - Retribuzioni e Lavoro, ISTAT • INFLATION • CPI indices- IMF International Financial Statistics • STOCK RETURNS • Datastream Equity Indexes Data • Three investing countries - US, Canada and Italy • Seven investing industries - Fin, Leisure, Manuf, Trade, Transports and Communic, Utilities, Other Services • Ten destination countries - Can, F, I, J, Nl, Swe, UK, US, Ge, RoW • Monthly observations of annual total returns on equities, wage growth rates and inflation Jan 1998- Dec 2004

11. Merton (1971) with constant investment opportunities and background risk • Equity portfolio • for investors,l • w*js,l= speculative*j+inflation*j(l)+LIR*j(s,l) • j equity hedges country j INFLATION if its return is positively correlated with j inflation • j equity hedges LIR in industry s of country l when its return is negatively correlated with wage growth in s,l

12. Equilibrium portfolio for investors,l • wjs,l =market share j+ inflation j(l)+LIR j(s,l) • Inflation component is positive for equity j • if the covariance of the j-th return with inflation in l exceeds the world average inflation covariance • LIR component is positive for equity j • when the covariance of the j-th return with wage in industry s of country l is lower than the world average wage covariance

13. Cooper and Kaplanis, RFS 1994 deviation of countryl inflation risk from the average world inflation risk deviation of industrys incountryl wage risk from average world wage risk Methodology Simulated empirical portfolio components • market shares • observed in data at the end of 2004 • inflation(l) • Regression of the inflation rate deviation on each equity index return • LI(s,l) • Regression of the wage growth rate deviation on each equity index return

14. Methodology Simulated empirical portfolios for each investing country l • S industry s,l portfolios • unrestricted national portfolio • weighted sum of S industry s,l portfolios • Weight is the relative labor compensation in industry • restricted national portfolio • portfolio suitable to hedge the average LIR in country l • intermediate risk aversion (l = 5) • fraction human wealth/total wealth (η = 0.63)

15. reported results refer to statistically significant estimates Results Compare • Simulated portfolio shares invested in equity j • Simulated labor income components • levels • pairwise statistical differences • When LIR is hedged at the industry level • When LIR is hedged at the country level

16. Results 1/ Optimal equity portfoliosa. US • ptf shares differ across industries

17. Results 1/ Optimal equity portfoliosb. Canada

18. Results 1/ Optimal equity portfoliosc. Italy • lower heterogeneity

19. weight is relative labor compensation in industrys,l Result 2/ Inflation vs LIR Hedging • within country, labor hedging motive prevails on inflation hedging in all countries • wrong inference based on hedging national LIR • across countries, labor (and inflation) hedging motive is stronger for US and Canada

20. Results 3/ LIR hedging motivesa. US • labor hedging remarkable and heterogeneous across industries in US and Canada

21. Results 2/LIR hedging Canada & Italy

22. Heterogeneity Across Industries - Robustness 1. test the difference among labor income hedging coefficients across investing industries and count the # of significantly different coefficients • evaluate the statistically significant distance between the industry portfolios and the national one and derive a measure of dispersion of industry portfolios around the national portfolio

23. Test on differences between industry ptf weights for each industry pair Number of industry pairs with statistical different weights Number of industry pairs with statistical different weights Results 3/Hedging income risk at industry level

24. Results 3/Industry vs National labor income hedging • Confirmed higher heterogeneity in US and Canada wrt Italy conjecture: inversely correlated with EPL and centralized bargaining

25. Conclusions • Sizeable labor hedging components in equity portfolios • Substantial heterogeneity across industries • more pronounced for US and Canada • Clear-cut role of occupational pension funds in hedging labor income risk - reduced where EP dampens industry wage shocks