Funds Investing

Key Points

• Investors are risk-averse and would like to minimize risk or be compensated for assuming any risk. Portfolio risk can be reduced by adding stocks that are not well correlated with the portfolio. In particular, the risk can be reduced by adding foreign stocks to a domestic portfolio because foreign stocks are not highly correlated with domestic stocks. Though holding foreign stocks is optimal, investors tend not to hold portfolios that contain an optimal exposure to foreign stocks. The underweighting of foreign stocks in a portfolio is referred to as the home bias.
• The evidence shows that the correlation between emerging markets and the U.S. market is 0.42, and that between the developed markets and the U.S. market is 0.58. If emerging market stocks and other developed market stocks are included in a domestic portfolio, there is an improvement in the risk-return trade-off from a U.S. investor’s portfolio. An optimal portfolio should contain about a 30 percent investment in other developed markets and another 10 percent in emerging markets. Compared to the optimal portfolio, U.S. investors invest only 7 percent in foreign stocks, emerging and developed markets combined. If other kinds of assets are considered, the home bias becomes even more severe.
• It is possible that the benefits of international investing are overstated, as the analysis does not account for varying correlations, trading costs and taxes, and different types of risk. These concerns are addressed along with the likely reasons for persistence.
• Avenues for investing internationally include American depository receipts, exchange-traded funds, and international mutual funds. With the availability of these instruments, an investor can realize the benefits of international investing without directly owning foreign stocks.
• Whether or not to hedge foreign portfolios against currency risk is a difficult question. While reducing risk is good, the cost of hedging currency risk may turn out to be too high. Some actively managed mutual funds do hedge currency risk, while others do not.

Bottom Line

Internationalizing a domestic portfolio is strongly recommended. Research based on the 1976-99 period estimates that an investment in developed countries and emerging markets would have increased a U.S. investor’s annual return by 3.78 percent while reducing the investor’s risk by 9.74 percent. Ideally, about 40 percent of the portfolio should be invested in foreign securities through ADRs, exchange-traded funds, and international mutual funds.

Possibly related posts: (automatically generated)
Bias in Future Market Conditions and Market Patterns

• Persistence of the Forward Rate Bias
• Persistence of the Forward Rate Bias (continue...)
• Range of Investment Aims
• The Management of Funds
• The Trading Process
• Where and How to Invest Internationally (continue...)
• Continuous Full Investment Without Hedging
• Currency Hedging
• Take Inside Look of Japan Fund
• Corporate Governance Ouside the United States: Recent Improvements