Chapter 13

International Portfolio Management: Theory and Method

Wan-Jiun Paul Chiou and Cheng-Few Lee

Abstract This paper investigates the impact of various nature to question the asset allocation of the unrestricted
investment constraints on the benefits and asset allocation of efficient frontier suggested by Markowitz (1952). Further-
1
the international optimal portfolio for domestic investors in more, understanding changes in the benefits of international
various countries. The empirical results indicate that local in- diversification strategies helps to structure dynamic portfo-lio
vestors in less-developed countries, particularly in East Asia rebalancing when the world financial market has been
and Latin America, benefit more from global diversification. increasingly integrated. To ensure the achievability of strate-
Although the global financial market is becoming more in- gies, the obstacle of the extreme allocations on the opti-mal
tegrated, adding constraints reduces but does not completely international portfolio, such as negative and enormous weights,
eliminate the diversification benefits of international invest- needs to be taken into account. This chapter ex-plores the
ment. The addition of portfolio bounds yields the following theory and method of global asset management by
characteristics of asset allocation: a reduction in the temporal investigating the attributes of the diversifying portfolio. We
deviation of diversification benefits, a decrease in time-vari- also provide the evidence of significance to include various
ation of components in optimal portfolio, and an expansion in investment constraints by observing the change in weights and
the range of comprising assets. Our findings are useful for mean-variance efficiency.
asset management professionals to determine target markets to Previous studies investigate the strategies of international
promote the sales of national/international funds and to portfolio management with short-selling constraints (for a more
manage risk in global portfolios. detailed discussion, see Cosset and Suret 1995; De Roon et al.
2001; De Santis and Gerard 1997; Driessen and Laeven 2007;
Keywords International portfolio management Investment Fletcher and Marshall 2005; French and Poterba 1991; Harvey
constraints 1995; Li et al. 2003; Novomestky 1997; and Obstfeld 1994).
Yet, the impact of other invest-ment restrictions on the global
diversification benefits re-mains unclear. There are three
reasons for portfolio man-agers to consider the unattainability
13.1 Introduction of the “corner solutions” on the efficient frontier. First, both
profitability and liquid-ity of the diversifying portfolio should
In the past three decades, financial markets throughout the be taken into account when asset allocation in international
world have experienced evolutions that leave challenges and markets is determined. The heavily positive/negative weights
opportunities to international portfolio management: more of investments in the minor markets recommended by less-
openness to domestic and foreign investors, increasing in- constrained strategies may cause illiquidity of the portfolio.
tegration with other countries, gradual liberalization from Second, the excessive foreign capital in- and out flows in minor
governmental control, and innovations of financial products markets tend to trigger instability in security prices. This may
and services. Specifically, as the investibility and the legal generate dra-matic variation in returns, risks, and correlations.
limitation to foreign investment vary across countries, it is Finally, in many countries, particularly developing nations,
governmen-tal regulations prohibit foreign investors to short
sell and/or
W.-J.P. Chiou ( )
Department of Finance, John L. Grove College of
Business, Shippensburg University, Shippensburg, PA
17257, USA e-mail: [email protected]
C.-F. Lee 1 The investiblity of the stock market is indicated by the degrees with
Department of Finance and Economics, Rutgers Business which foreign investors can trade as do local investors in the domestic
School, Rutgers University, New Brunswick, NJ 08854, USA markets and the liquidity of assets. See Bae et al. (2004).

C.-F. Lee et al. (eds.), Handbook of Quantitative Finance and Risk Management, 221
DOI 10.1007/978-0-387-77117-5_13, c Springer Science+Business Media, LLC 2010
222 W.-J.P. Chiou and C.-F. Lee

to hold more than a certain proportion of company shares.

2 13.2 Overview of International
From legal and institutional aspects, a large percentage of Portfolio Management
foreign capital allocation to securities in those small finan-
cial markets is impractical. Accordingly, the results of this International diversification has been a strong trend for
chapter are more realistic for asset management since illiq- investors in all countries after the mid-1990s. For Euro-pean
uidity of portfolio and variation in return and volatility, as investors, such as ones in the Netherlands and the U.K.,
well legal limitations, are considered when the optimal overseas portfolios play an important role in asset management.
port-folio strategies are formed. However, this is a relatively newer option in the portfolio for
To appropriately estimate the effectiveness of interna-tional investors in the U.S. and most emerging markets. The
portfolio management, two straightforward measures, the enormous growth of financial markets outside North America
increase in risk-adjusted premium by investing in the after the mid-1980s is one of major reasons that trigger global
maximum Sharpe ratio (MSR) portfolio and the reduction in diversification. Table 13.1 presents the average growth rates of
the volatility by investing the minimum variance portfo-lio market value in major 34 countries from 1993 to 2005 and the
(MVP) on the international efficient frontiers, are used. weights of world market capi-talization as of the end of 2005.
Additionally, this chapter extends the study in diversification These sample countries are also grouped into seven regions:
benefits by including over-time comparison and cross-region East Asia, North America, Latin America, North Europe,
analyses. An increase of correlations and reduction of returns West/Central Europe, South Europe, and Oceania. The global
in the global market cast a shadow of doubt on the effective- value-weighted average annual growth rate is 10.5% during the
ness of international investment. An intertemporal analysis of period. The coun-tries with the largest growth in market value
the benefits of diversification is helpful to determine the were Finland, Turkey, and Greece, in which the increase rates
impact of integration of the international financial market. are twice more than the world average. The variation in the
Our empirical findings confirm the benefits of inter- growth of market value within each group of countries at a
national portfolio management with various investment given developmental stage and in various areas is considerable.
constraints. The cross-country comparison suggests that do- The fact that the equity markets in developing countries ex-
mestic investors in emerging markets, particularly in East perienced a larger increase in value indicates the significance
Asia and Latin America, benefit more from international di- of international diversification for the U.S. investor.
versification. It is also found that the global diversification The magnitude of foreign markets also validates the trend
benefits vary as the world financial market has became toward international diversification. In the early 1970s, the
more integrated. Although the lower and upper bounds of New York Stock Exchange represented more than 60% of the
weights worsen the mean-variance efficiency of the optimal world market value of less than $1 trillion in total. As shown in
portfo-lio, they generate some desired attributes for asset Figure 13.1, the size of the world market multi-plied
manage-ment and therefore enhance the feasibility of asset significantly in the next three decades and at the end of 2005,
allocation strategies. Specifically, the addition of the stock market value in the above 34 countries was about 38
overweighting invest-ment constraints substantially reduces trillion. The shares among various regions varied drastically.
the time-variation in gains and weights of the global The percentage of the U.S. equity market varies from more
diversification. The expan-sion of coverage in the optimal than 50% to less than 40% in the early 1990s and back to 43%
portfolio makes the asset al-locations more realistic. by the end of 2005. The East Asia and Ocea-nia region, which
The chapter is organized as follows. Section 13.2 reviews made up more than one-third of the mar-ket capitalization in
development of global portfolio management. Section 13.3 the world in the early 1990s, reduced to about one-fifth at the
reviews literature. The estimate of the benefits of interna-tional end of 2005. Europe represents about one-third of the global
diversification is described in Sect. 13.4. Section 13.5 reports market value. The stock markets in developed countries
the empirical results of the benefits of international consistently represented more than 90% of the world
diversification. The over-time examination of components of capitalization. On the other hand, the capitaliza-tion of the
the optimal portfolios is reported in Sect. 13.6. Conclusions are emerging markets is small, and only Brazil, South Korea, and
presented and relevant issues are discussed in Sect. 13.7. Taiwan were of a share greater than 1% in the world market as
of the end of 2005.
International diversification is inspired by two desired
characteristics in portfolio management: a low global
2 For instance, the ownership of listed companies by foreigners can-not correlation to decrease the portfolio volatility and the ex-
exceed the limit of 10% in Chile, 25% in South Korea, and 10% in Taiwan.
In Brazil, international institutional investors cannot own more than 49% pansion of investment targets to allow investors to allocate
of voting share. In Switzerland, corporations are likely to is-sue asset toward the markets with higher expected return. The
international investors special shares that are traded at a premium over the
same stocks available exclusively to Swiss nationals. above attributes eventually lead to a superior mean-
variance
13 International Portfolio Management: Theory and Method 223

Table 13.1 Capitalization and performance of markets

Panel A: Developed countries
Sharpe ratio
Country Cap growth Cap weight Mean return Region Median St. Dev. Max Time Min Time
Australia 14:81% 2:08% 0:113 Oceania 0:001 0.069 0:201 Dec-05 0.122 Oct-01
Austria 15:14% 0:33% 0:087 C/W Europe 0:091 0.134 0:392 Dec-05 0.172 Jun-00
Belgium 12:72% 0:78% 0:081 C/W Europe 0:020 0.127 0:376 Aug-98 0.196 Apr-03
Canada 14:96% 3:83% 0:107 N. America 0:024 0.093 0:219 Sep-00 0.169 Aug-94
Switzerland 13:09% 2:41% 0:124 C/W Europe 0:117 0.151 0:411 Mar-98 0.197 Apr-03
Germany 10:16% 3:15% 0:096 C/W Europe 0:046 0.111 0:309 Jul-98 0.199 Apr-03
Denmark 14:28% 0:48% 0:137 C/W Europe 0:060 0.093 0:312 Apr-98 0.142 Apr-03
Spain 19:11% 2:48% 0:105 C/W Europe 0:005 0.116 0:295 Aug-98 0.145 Aug-93
Finland 24:37% 0:54% 0:114 N. Europe 0:081 0.162 0:375 Jan-93 0.261 Apr-00
France 13:13% 4:20% 0:111 C/W Europe 0:057 0.091 0:254 Jan-00 0.139 Apr-03
U.K. 9:60% 7:89% 0:093 C/W Europe 0:025 0.133 0:291 Mar-98 0.293 Apr-03
Hong Kong 14:97% 2:72% 0:125 E. Asia 0:002 0.115 0:251 Sep-94 0.145 Oct-02
Ireland 16:12% 0:29% 0:099 C/W Europe 0:002 0.140 0:372 May-98 0.200 Mar-03
Italy 15:04% 2:06% 0:077 S. Europe 0:010 0.083 0:179 Apr-98 0.163 Apr-03
Japan 5:36% 11:80% 0:009 E. Asia 0:089 0.060 0:048 Jul-97 0.240 Sep-98
Netherlands 10:24% 1:23% 0:117 C/W Europe 0:122 0.158 0:360 Jun-98 0.213 Apr-03
Norway 20:00% 0:49% 0:116 N. Europe 0:015 0.090 0:241 Jan-98 0.183 Oct-02
New Zealand 8:14% 0:10% 0:067 Oceania 0:034 0.136 0:254 Nov-05 0.249 Dec-00
Singapore 13:62% 0:66% 0:084 E. Asia 0:023 0.107 0:223 Feb-96 0.190 Sep-98
Sweden 14:39% 1:14% 0:136 N. Europe 0:013 0.128 0:341 Mar-00 0.139 Oct-02
U.S.A. 10:75% 43:88% 0:114 N. America 0:114 0.171 0:393 Jan-00 0.147 Apr-05
Average 10:47% 4:41% 0:097 0:021 0.079 0:192 Apr-98 -0.145 Apr-03
Panel B: Emerging markets
Sharpe ratio
Country Cap growth Cap weight Mean return Region Median St. dev. Max Month-Year Min Month-Year
Argentina 7:48% 0:12% 0:185 L. America 0:019 0.101 0:165 Mar-94 0.235 Jun-02
Brazil 19:78% 1:23% 0:193 L. America 0:024 0.089 0:230 Jul-97 0.181 Oct-02
Chile 12:48% 0:35% 0:182 L. America 0:046 0.173 0:368 Nov-94 0.217 Oct-02
Greece 22:19% 0:37% 0:133 S. Europe 0:009 0.105 0:229 Oct-99 0.180 Jul-95
Indonesia 15:84% 0:21% 0:082 E. Asia 0:064 0.108 0:149 Dec-05 0.279 Oct-98
Korea, S. 15:72% 1:85% 0:077 E. Asia 0:042 0.079 0:206 Dec-05 0.239 Jan-98
Malaysia 5:37% 0:47% 0:064 E. Asia 0:013 0.126 0:233 Jan-94 0.272 Nov-98
Mexico 4:28% 0:62% 0:223 L. America 0:045 0.133 0:437 Feb-94 0.131 Feb-99
Philippines 7:62% 0:10% 0:029 E. Asia 0:104 0.171 0:266 Oct-95 0.269 Nov-01
Portugal 16:08% 0:17% 0:045 C/W Europe 0:041 0.127 0:283 May-98 0.242 May-03
Thailand 6:11% 0:32% 0:060 E. Asia 0:002 0.141 0:213 Jan-94 0.273 Sep-98
Turkey 24:10% 0:42% 0:129 S. Europe 0:004 0.064 0:143 Jan-94 0.136 Feb-95
Taiwan 12:74% 1:23% 0:062 E. Asia 0:040 0.065 0:122 Sep-97 0.174 Oct-02
Average 12:21% 0:57% 0:108 0:002 0.066 0:129 Feb-94 0.137 Oct-02
The growth rate of capitalization during the period of 1992:12–2005:12 and the world capitalization weight as of the end of 2005 in each country
are reported. The mean of raw return for each market from 1988:01 to 2005:12 is annualized. The mean, median, standard deviation, maximum,
and minimum of the time series of the monthly Sharpe ratio for each market are also presented. The averages for developed countries and
emerging markets are calculated by their value-weighted portfolios.

efficiency of holding portfolio. However, several impedi-ments developed countries are higher than the ones in the emerging
to global diversification in recent years are discussed. The first markets. The countries of the maximum mean-variance ef-
criticism of global diversification is that consistently higher ficient domestic portfolio are the U.S., Switzerland, the
returns in domestic markets in certain countries chal-lenge the Netherlands, and Finland. It is consistent with previous find-
need of overseas investment. It is questionable to claim greater ings that the mean-variance efficiency of equity prices in
expected return in the future by using the past superior emerging markets is lower due to higher volatility (Bekaert and
performance. Table 13.1 summarizes the value-weighted Harvey 2003). Furthermore, the cross-area disparity of
average performance and the dynamics of the monthly Sharpe equity returns among emerging markets is considerable.
ratio for each market. The raw return in de-veloping countries, Specifically, the stock return in Latin America outperformed
on average, is higher than the stock mar-kets in developed
the ones in other regions, while the equities in East Asian
countries. However, the Sharpe ratios in
countries performed worse than the rest of the world.
 224 W.-J.P. Chiou and C.-F. Lee

Millions of U.S. Dollars

40,000,000
Oceania

35,000,000

30,000,000 North America

25,000,000

20,000,000 Latin America

15,000,000
East Asia

10,000,000

5,000,000 Europe

0
1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005

Fig. 13.1 Stock market capitalization in the world. The equity market capitalization in different regions from 1992 to 2005 is demonstrated

Table 13.1 also indicates significant time-variation of risk- considerable for the emerging markets with the countries that
adjusted performance in each stock market. Compared to the are in the different regions. All means of correlation coeffi-
means of the Sharpe ratio, the time variation, which is mea- cient in the second period are increasing and positive. This
sured by standard deviation, of the Sharpe ratio for each mar- finding is consistent with the enhancement of integration of the
ket is substantial. For the developed countries, the maximum world financial market over the past two decades.
domestic Sharpe ratio most likely occurred in 1998 and 2005, Table 13.2 also shows the means of the correlation co-
while for most emerging markets this occurred before 1998. efficients of each country with other countries grouped by
The local investors in the majority of emerging markets gen- regions in two sub-periods. The developed countries, in gen-
erated the worst risk-adjusted performance in 1998 due to eral, demonstrate higher correlations with other markets than
financial crises. On the other hand, investors in developed the emerging markets do. Most countries also have the high-est
countries experienced the largest loss in 2002 and 2003 be- coefficients of correlation with the other countries in their
cause of the evaporation of high-tech bubbles after 2000 and home region and with the ones in North America. Although the
the economic recession worsened by the terrorist attack in magnitude of correlations increases over time, the phe-nomena
2001. Furthermore, there are nonsynchronous movements of that the emerging markets are less correlated with other
mean-variance efficiency across countries, which imply the countries can be constantly observed in the two sample periods.
potential gains to domestic investors if they diversify their The fact that most markets are less correlated with the countries
portfolios globally. For instance, there are ten markets of the from other regions indicates possible diversifi-cation benefits
best mean-variance efficiency and six markets of the worst in from inter-continent investments. In addition, the stock markets
1998. Similarly, four countries had the highest Sharpe ra-tio, in the rest of the world tend to have con-siderable co-
and three countries had the lowest in 2000. This suggests that movements with the U.S. markets.
cross-market performances can differ drastically in the same Third, the existence of home bias in international asset al-
year and that local investors may avoid losses in their home location suggests investors consider the barriers to overseas
markets by allocating their funds optimally in other countries. investments costly. The factors such familiarity with financial
markets in other countries, political risk, market liquidity and
Second, it has been observed that international correla-tions efficiency, regulation on foreign ownership of domestic cor-
have trended aloft over the past decades. As shown in Table porations, transaction costs, levies and taxes, and exchange rate
13.2, the intertemporal comparison provides evidence of risk, rationalize why an investor would want to over-weigh his
enhancement of correlation in the international financial or her local portfolio compared with the weights of asset in the
market. The means of correlation of each market with all other rest of the world. However, previous research suggests that the
countries in the second period is persistently greater than the costs related to the previous variables are smaller than the
ones in the first period. In the first period, some markets are improvement of mean-variance brought by international
negatively correlated or almost uncorrelated with certain areas. diversification. This implies that overseas asset allocation
The enhancement of correlation is particularly should not be avoided entirely.
 13 International Portfolio Management: Theory and Method
Table 13.2 Coefficients of correlation among markets
Panel A: Developed countries
World average Latin America North America East Asia Central/West Europe North Europe South Europe Oceania
88–96 97–05 88–96 97–05 88–96 97–05 88–96 97–05 88–96 97–05 88–96 97–05 88–96 97–05 88–96 97–05
Australia 0.28 0.55 0.14 0.58 0.43 0.66 0.25 0.53 0.29 0.54 0.43 0.57 0.04 0.40 0.66 0.70
Austria 0.31 0.43 0.07 0.39 0.17 0.41 0.30 0.31 0.42 0.56 0.34 0.39 0.34 0.34 0.22 0.52
Belgium 0.32 0.45 0.06 0.32 0.41 0.48 0.26 0.23 0.51 0.68 0.35 0.47 0.16 0.37 0.15 0.42
Canada 0.31 0.56 0.13 0.61 0.65 0.79 0.34 0.47 0.33 0.58 0.39 0.67 0.02 0.45 0.42 0.63
Switzerland 0.32 0.51 0.02 0.40 0.39 0.58 0.25 0.33 0.50 0.69 0.38 0.55 0.17 0.40 0.27 0.52
Germany 0.35 0.57 -0.01 0.52 0.33 0.71 0.26 0.36 0.58 0.73 0.42 0.69 0.19 0.52 0.22 0.54
Denmark 0.30 0.50 0.01 0.47 0.27 0.65 0.20 0.31 0.49 0.65 0.45 0.59 0.15 0.38 0.19 0.46
Spain 0.39 0.57 0.22 0.56 0.40 0.66 0.29 0.38 0.51 0.71 0.55 0.63 0.18 0.51 0.42 0.58
Finland 0.28 0.40 0.12 0.37 0.33 0.60 0.27 0.25 0.32 0.46 0.55 0.55 0.03 0.43 0.38 0.41
France 0.33 0.59 0.10 0.50 0.40 0.72 0.24 0.35 0.53 0.76 0.35 0.73 0.17 0.53 0.23 0.55
U.K. 0.38 0.56 0.06 0.51 0.51 0.70 0.29 0.38 0.54 0.70 0.54 0.63 0.10 0.48 0.45 0.57
Hong Kong 0.33 0.47 0.17 0.55 0.49 0.57 0.41 0.54 0.34 0.40 0.35 0.43 0.10 0.26 0.30 0.55
Ireland 0.37 0.48 0.09 0.43 0.40 0.58 0.33 0.32 0.51 0.61 0.50 0.51 0.22 0.43 0.34 0.53
Italy 0.28 0.49 0.05 0.46 0.29 0.56 0.25 0.26 0.38 0.66 0.40 0.59 0.15 0.49 0.19 0.46
Japan 0.27 0.38 0.06 0.34 0.26 0.50 0.21 0.40 0.40 0.36 0.38 0.40 0.06 0.24 0.26 0.52
Netherlands 0.40 0.58 0.02 0.49 0.51 0.68 0.30 0.38 0.61 0.76 0.51 0.65 0.16 0.47 0.39 0.55
Norway 0.34 0.54 0.14 0.58 0.41 0.66 0.24 0.39 0.46 0.63 0.55 0.54 0.10 0.49 0.38 0.61
New Zealand 0.25 0.48 0.06 0.44 0.28 0.51 0.22 0.48 0.27 0.48 0.39 0.47 0.12 0.39 0.66 0.70
Singapore 0.40 0.47 0.15 0.55 0.48 0.57 0.52 0.57 0.44 0.37 0.45 0.42 0.17 0.31 0.37 0.60
Sweden 0.38 0.55 0.13 0.52 0.44 0.71 0.31 0.39 0.50 0.66 0.57 0.65 0.19 0.53 0.47 0.55
U.S.A. 0.32 0.56 0.19 0.57 0.65 0.79 0.29 0.45 0.39 0.62 0.40 0.65 0.00 0.46 0.29 0.54
Panel B: Emerging markets
World average Latin America North America East Asia Central/West Europe North Europe South Europe Oceania
88–96 97–05 88–96 97–05 88–96 97–05 88–96 97–05 88–96 97–05 88–96 97–05 88–96 97–05 88–96 97–05
Argentina 0.06 0.36 0.18 0.57 0.16 0.42 0.05 0.33 0.02 0.31 0.02 0.36 0.14 0.36 0.17 0.37
Brazil 0.10 0.52 0.12 0.67 0.08 0.63 0.08 0.42 0.08 0.56 0.22 0.53 0.16 0.41 0.13 0.54
Chile 0.08 0.51 0.14 0.66 0.14 0.61 0.14 0.50 0.04 0.46 0.08 0.52 0.01 0.48 0:03 0.56
Greece 0.19 0.39 0.09 0.38 0.06 0.40 0.11 0.23 0.29 0.50 0.18 0.45 0.35 0.33 0.15 0.38
Indonesia 0.14 0.34 0.05 0.36 0.20 0.35 0.20 0.48 0.11 0.26 0.14 0.25 0.13 0.19 0.20 0.42
Korea, S. 0.15 0.38 0.06 0.33 0.19 0.42 0.22 0.45 0.13 0.32 0.23 0.39 0:07 0.27 0.16 0.53
Malaysia 0.33 0.34 0.10 0.38 0.41 0.36 0.46 0.49 0.33 0.26 0.37 0.26 0.16 0.20 0.30 0.36
Mexico 0.16 0.52 0.22 0.65 0.25 0.69 0.21 0.48 0.12 0.48 0.20 0.55 0.00 0.45 0.14 0.57
Philippines 0.27 0.37 0.15 0.41 0.34 0.43 0.39 0.51 0.24 0.29 0.20 0.26 0.16 0.20 0.29 0.48
Portugal 0.28 0.46 0.09 0.36 0.20 0.50 0.18 0.26 0.40 0.64 0.32 0.57 0.41 0.40 0.28 0.42
Thailand 0.28 0.41 0.17 0.42 0.36 0.46 0.41 0.57 0.26 0.31 0.21 0.31 0.21 0.18 0.20 0.62
Turkey 0.09 0.38 0.06 0.48 0:05 0.52 0.11 0.25 0.11 0.38 0.03 0.51 0.35 0.33 0.01 0.41
Taiwan 0.15 0.40 0.14 0.54 0.12 0.49 0.25 0.47 0.13 0.32 0.14 0.36 0.05 0.28 0.06 0.45
The averages of unconditional coefficients of correlation of each country with other countries of different regions during two periods, 1988:01–1996:12 and 1997:01–2005:12 are reported.

225
226 W.-J.P. Chiou and C.-F. Lee

13.3 Literature Review In sum, previous studies document the benefits of global
diversification with constraints such as short-sales. The in-
Previous empirical evidence suggests that investment con- crease in correlations of international financial markets does
straints may not completely eliminate the benefits brought not completely eliminate the benefits because of the disper-
about by international diversification. Bekaert and Urias sion of returns among countries. The difference of cultures,
(1996), Chiou (2008), Chiou et al. (2009), De Roon et al. natural endowments, and institutional systems among mar-
(2001), Driessen and Laeven (2007), Harvey (1995), Li et al. kets cause the dispersion of returns among markets. The gap
(2003), Pástor and Stambaugh (2000), and Wang (1998) con-
of understanding regarding the time-series of the benefits of
firm the benefits of international diversification even when
constrained international diversifications needs to be filled.
short-sales are not allowed. Cosset and Suret (1995) find that
including securities from high political-risk countries into the
portfolio can increase mean-variance efficiency. Considering 13.4 Forming the Optimal Global Portfolio
geographical restrictions, De Roon et al. (2001) find that in-
vestors in East Asia can still generate benefits from diversi- Suppose a representative investor desires to minimize the
fying their portfolios by investing in other countries in Latin volatility of her portfolio, given the same return, by allo-
America. Green and Hollifield (1992) and Jagannathan and Ma cating funds among international markets. The expected re-
(2003), on the other hand, investigate the impacts of im-posing turns in excess of the risk-free interest rate and the variance-
short-sales and upper-bound investment constraints on mean- covariance of N international asset returns can be expressed
variance efficiency and portfolio risk. Errunza et al. (1999) as a vector T D Π1; 2; : : : ; N and a positive definite matrix
find that U.S. investors can utilize domestically traded V, respectively. Let be the set of all real vectors of
American Depositary Receipts (ADRs) to duplicate the ben- weighting wT such that wT1 D w C w C : : : C w D 1,
1 2 N
efits of international diversification. where 1 is an N -vector of ones. We further assume that the
The degree of international market integration is critical to best predictors of means, variances, and covariances are
the effectiveness of international diversification. Bekaert and their historical averages. The investor thus follows the
Harvey (1995), Bekaert et al. (2005), De Jong and De Roon method of Markowitz (1952) to form the global efficient
(2005), and Errunza et al. (1992) suggest that the world market frontier. The problem of the optimal portfolio selection is
is mildly segmented and that the degree of global market then expressed as a Lagrange’s equation:
integration varies throughout time. The integration of
international financial markets, in general, has gradually in- T T T
2 w VwC p w C 1 w 1 ; (13.1)
creased, but the emerging markets are still more segmented
than those in developed countries. Bekaert et al. (2005) find
where p denotes the expected return on the portfolio, and the
that the correlations among individual stock price do not nec-
shadow prices and are two positive constants. The quadratic
essarily increase when the international financial market is
programming solution for asset spanning without
more integrated, while the idiosyncratic risk does not show a
investment constraints is:
particular time trend. Given the change in the world financial
market, an intertemporal study in international diversification
1 1
benefits would be useful. wp D V C V 1: (13.2)
The institutional and cultural heterogeneities among
Various weighting constraints are considered. It is well-known
countries are key factors determining nonsynchronous move-
that short-selling is not allowed for foreign investors in many
ment of security prices among markets. Beck et al. (2003) and
countries, particularly in less developed nations (see De Roon
Demirgüç-Kunt and Maksimovic (1998) suggest that the
et al. 2001; Harvey 1995; Li et al. 2003; Pástor and Stambaugh
international differences of financial markets can be ex-plained
2000). Furthermore, the investor considers the liquidity of
by natural endowments and legal tradition. La Porta et al.
portfolio when global asset allocation is de-termined. To reflect
(1998, 2000), Djankov et al. (2003, 2008) show how law
the argument by Green and Hollifield (1992) and Jagannathan
affects the protection to investors. Stulz and Williamson (2003)
and Ma (2003), the relative magni-tude of market value in each
document that liberalization and development of fi-nancial
country is considered when the upper boundaries of weighting
markets relate to cultural background such as major religion
and language. Bekaert and Harvey (2003) report the major are characterized. The subset of portfolio weights P U with
characteristics of emerging markets and their chrono-logical short-sale and over-weighting investment constraints .SS C
innovations. The differences in cultural background, natural OW.U // can be described as:
endowments, institutional systems, and legal tradition deter
integration of international financial markets so that in-vestors PU D fwp 2 W 0 wi U w.C ap/i 1;
may generate gains from overseas diversification.
i D 1; 2 : : : ; N g; U > 1; (13.3)
13 International Portfolio Management: Theory and Method 227

where w.Cap/i is the proportion of the market value of each efficient frontiers also does not follow a consistent direction
country i in the world, and U is any real number. The or pattern. The efficient frontier first shifts to the northwest
restriction of weights is then incorporated in Lagrange’s from 1993 to 1994 but then moves to the southeast (reduc-
Equation (13.1). Since the incentives of diversification are tion in mean-variance efficiency) from 1994 to 1997. The
not only to seek higher yields but also to reduce volatility, positions of optimal portfolios hover around the same gen-
the Maximum Sharpe ratio (MSR) represents the highest eral area from 1998 to 1999. In 2000, the frontier moves
mean-variance efficiency that can be achieved by the northwest, consistent with the U.S. market dot-com boom.
international efficient frontier. Specifically, Then, from 2001 to 2003, the frontier moves noticeably to
the southeast, seemingly reflective of the U.S. market crash.
1
The period from 2002 to 2003 is by far the least mean-
T T T
MSRJ D maxfwpg wp = wp Vwp 2 w p 2 PJ : variance efficient of our sample period. Then the frontier
(13.4) moves north-west again in 2004 and 2005. The movement
For domestic investor in country i , the greatest increase in of the effi-cient frontiers seems to reflect the world markets
unit-risk return brought by global diversification is and busi-ness cycles.
Figure 13.3 graphically demonstrates the time-series of
potential diversification benefits to the domestic investors.
•i;J D MSRJ SRi ; (13.5) Graph A shows that the average improvement of mean-
1
variance efficiency to the local investor was at its peak from
where SRi D i =Vi 2 is the Sharpe ratio, and V i is the vari-
ance of the domestic portfolio in country i . 1993 to 1994 when only short-sales constraint is considered.
The other measure of benefits of diversification is the On the other hand, when the limit of over-weighting invest-
maximum reduction in volatility as a result of international ment is taken into account, ı is at its maximum during 1996
diversification. Elton et al. (2007) suggest that investors may and 2000. In Graph B, " with various restrictions was
seek to minimize the variance of a portfolio because of the lack slightly lower from 1996 to 1998 and from 2003 to 2005.
of predictability of expected returns. In this case, an in-vestor The in-tertemporal change of the benefit of risk reduction is
may want to construct a minimum-variance portfolio (MVP).
not as considerable as that of the one of mean-variance
The weighting of the MVP can be characterized as:
efficiency improvement.
The cross-strategy comparison shows that the benefits
wMVP D wp W minfwp g w
T
p V wp w
T
p 2 PJ : (13.6) un-der various constraints are not proportional. In Graph A,
for instance, the divergence of the Sharpe ratio benefits
among various trading limits is significant when the Sharpe
The maximum decline in volatility by diversifying interna-
ratio benefit of the no-short-selling portfolio is high. A
tionally with various investment constraints is
similar pat-tern can be found in Graph B. This suggests that
1 the effec-tiveness of the less restrictive diversifying
©i;J D 1 wT ; VwMVP;J=Vi 2
: (13.7)
MVP J strategies is more sensitive to the variants of asset returns in
the menu. Con-sideration of these constraints eliminates
In this chapter, the global efficient frontiers and the Sharpe uncertainty in port-folio performance since some portion of
ratio are estimated by using monthly returns in the previ- investment shifts to the second-best alternatives, which
ous 5 years. The time-series of ı i;J and "i;J with various in- generally are the national indices representing larger
vestment constraints are generated by time-rolling efficient markets with high mean-variance efficiency.
frontiers. The weights for the MSR portfolio and the MVP Table 13.3 reports means of ı and " of each country over the
under various investment constraints in each month are also sample period. The gains of international diversification to
calculated. local investors in emerging markets, both the improvement of
mean-variance efficiency and the decrease in volatility, are
greater than the ones in developed countries. This result holds
13.5 The Benefits of International for the various scenarios of weighting constraints. The
diversification benefits to the investors in emerging markets are
Diversification Around the World
eroded considerably by restrictive upper bounds, espe-cially ı.
The domestic investors in developed countries still can increase
Figure 13.2 exhibits the efficient frontiers of the global port- mean-variance efficiency of their portfolios by approximately
folio at the end of each year from 1993 to 2005. Because of the 0.136 and reduce volatility by 2.5% via the global
time-variations in mean-variance efficiency and corre-lations diversification with constraints of SS C OW.3/.
among markets, the shape and size of efficient fron-tiers vary Table 13.3 also shows that the comparative advantages
noticeably from 1993 to 2005. The movement of vary from region to region. The local investors in East Asia,
228 W.-J.P. Chiou and C.-F. Lee

Fig. 13.2 Mean-variance efficient

Monthly Expected Return
frontiers: 1993–2005. This figure
0.05
shows the short-sale constrained
international efficient frontiers at
the beginning of each year from 0.04
1993 to 2005. The efficient
frontiers are constructed by the 94 93
0.03
monthly returns in previous 5 years 00
01
96
99
0.02 98
97 03
02
05
0.01
04

95
0.00
0.00 0.02 0.04 0.06 0.08 0.10 0.12 0.14 0.16 0.18
−0.01
Monthly St. Dev.

Fig. 13.3 The benefits of

international diversification. The
Panel A: δ
time-series of the means of the
benefits of international
diversification for all sample
countries are presented. The
increase in the risk-adjusted
premium and the decrease in
volatility of domestic portfolio by
international diversification are
•i;J D MSRJ SRi and 1
© D 1w T Vw =V
i;J MVP ;J MVP;J i 2 ,
respectively

Panel B: ε

on average, enjoy superior increments in the risk-adjusted efits of incorporating overseas stocks in their portfolios pri-
premium and the greatest shrinkages in volatility from global marily are to reduce risk. The benefits for investors in
diversification. For home investors in Latin America, the ben- Europe and North America are relatively trivial compared to
the ones
13 International Portfolio Management: Theory and Method 229

Table 13.3 The benefits of Panel A: Developed countries

international diversification
to domestic investors SS SS C OW(10) SS C OW(5) SS C OW(3)
ı " ı " ı " ı "
i;J i;J i;J i;J i;J i;J i;J i;J

Australia 0:3472 2:03% 0:2475 1:94% 0:2196 1:78% 0:1993 1:64%

Austria 0:4358 2:27% 0:2693 2:18% 0:2506 2:07% 0:2351 1:94%
Belgium 0:2563 1:49% 0:1937 1:42% 0:1584 1:31% 0:1318 1:18%
Canada 0:2954 2:28% 0:2614 2:13% 0:2444 2:08% 0:2293 1:99%
Switzerland 0:1908 1:90% 0:0953 1:82% 0:0603 1:76% 0:0395 1:67%
Germany 0:2588 2:77% 0:1803 2:68% 0:1375 2:52% 0:1206 2:33%
Denmark 0:2221 2:09% 0:1609 1:91% 0:1187 1:80% 0:0956 1:67%
Spain 0:2403 3:21% 0:1575 3:08% 0:1467 3:04% 0:1387 2:89%
Finland 0:1875 6:04% 0:1217 5:98% 0:0965 5:93% 0:0862 5:84%
France 0:2776 2:19% 0:1645 2:15% 0:1156 2:06% 0:0837 1:95%
U.K. 0:2938 0:85% 0:1813 0:60% 0:1487 0:51% 0:1311 0:39%
Hong Kong 0:2726 5:21% 0:1450 5:16% 0:1094 5:14% 0:0876 5:11%
Ireland 0:2639 2:38% 0:1950 2:22% 0:1553 2:12% 0:1316 1:95%
Italy 0:3044 3:75% 0:2413 3:63% 0:2063 3:54% 0:1806 3:39%
Japan 0:4308 3:05% 0:3196 2:97% 0:2835 2:87% 0:2669 2:75%
Netherlands 0:1968 1:51% 0:1307 1:42% 0:0975 1:33% 0:0783 1:25%
Norway 0:3253 3:55% 0:2500 3:49% 0:1966 3:39% 0:1810 3:24%
New Zealand 0:3248 3:52% 0:2549 3:45% 0:2167 3:34% 0:1974 3:21%
Singapore 0:3175 3:69% 0:1434 3:47% 0:1073 3:42% 0:0859 3:36%
Sweden 0:2028 4:47% 0:1520 4:29% 0:1188 4:18% 0:1007 4:09%
U.S.A. 0:1617 1:01% 0:0995 0:81% 0:0707 0:76% 0:0474 0:63%
Average 0:2765 2:82% 0:1888 2:70% 0:1552 2:62% 0:1356 2:50%
Panel B: Emerging markets
SS SS C OW(10) SS C OW(5) SS C OW(3)
ı " ı " ı " ı "
i;J i;J i;J i;J i;J i;J i;J i;J

Argentina 0:3163 9:32% 0:1914 9:11% 0:1814 8:99% 0:1699 8:88%

Brazil 0:2756 9:64% 0:1778 9:51% 0:1508 9:42% 0:1307 9:28%
Chile 0:2344 4:40% 0:1511 4:21% 0:1195 4:10% 0:1025 3:97%
Greece 0:3178 5:63% 0:1884 5:54% 0:1532 5:44% 0:1223 5:31%
Indonesia 0:4113 11:18% 0:2806 11:00% 0:2534 10:92% 0:2396 10:83%
Korea, S. 0:3924 7:14% 0:2927 6:89% 0:2469 6:78% 0:2286 6:65%
Malaysia 0:3113 4:93% 0:1750 4:86% 0:1452 4:80% 0:1285 4:73%
Mexico 0:2054 6:82% 0:0725 6:75% 0:0687 6:58% 0:0617 6:39%
Philippines 0:3538 6:59% 0:2136 6:52% 0:1796 6:46% 0:1570 6:39%
Portugal 0:2951 2:96% 0:2185 2:86% 0:1926 2:74% 0:1799 2:61%
Thailand 0:3116 8:46% 0:1881 8:26% 0:1688 8:13% 0:1517 8:02%
Turkey 0:3426 14:80% 0:2240 14:61% 0:1676 14:54% 0:1515 14:43%
Taiwan 0:3754 6:89% 0:2739 6:71% 0:2386 6:66% 0:2175 6:49%
Average 0:3187 7:60% 0:2037 7:45% 0:1743 7:35% 0:1570 7:23%
The medians of benefits of international diversification with short-sales (SS) and various sets of short-sale plus
over-weighting (SS C OW(U )) investment constraints to domestic investor in different countries are reported.
The increase in the risk-adjusted premium and the decrease in volatility of domestic portfolio by
1
T
international diversification are •i;J D MSRJ SRi and ©i;J D 1 w MVP;JVwMVP;J=Vi
2
, respectively.

in the rest of world. The relations of the more constrained 13.6 The Optimal Portfolio Components
di-versification benefits among regions are similar to the
results of the less constrained portfolios. Table 13.4 shows the average weight of each country for the
In the long term, the international diversification benefits maximum Sharpe Ratio (MSR) portfolio and the MVP over
are time-varying and do not fall significantly. The more re- the period. The comparison of components in the op-timal
strictive upper bounds of portfolio weights shrink the bene- portfolios under various investment constraints indi-cates
fits of international diversification and their temporal varia-
the infeasibility of less restrictive diversifying strate-gies.
tion. The optimal global diversifying strategies indeed
For the portfolio with short-sale restrictions, weighting in
gener-ate benefits to the local investors, even though the
short-sale and over-weighting constraints are increasingly emerging markets is disproportionate to its distribution in
restrictive. In general, local investors in emerging markets, the world capital market value. On average, the investors
particularly in East Asia and Latin America, benefit more who wish to maximize portfolio mean-variance efficiency
from international diversification. This result holds for should place 31.41% of wealth in emerging markets, which
global portfolios with various investment restrictions. repre-sent merely 7.4% of total market value of all
countries at the end of 2005. Among them, although the
Chilean equity
230 W.-J.P. Chiou and C.-F. Lee

Table 13.4 Means of portfolio weights

Panel A: Developed countries
MSR Portfolio MVP
SS SS C OW(10) SS C OW(5) SS C OW(3) SS SS C OW(10) SS C OW(5) SS C OW(3)
Australia 0.0010 0.0404 0.0211 0.0131 0.0180 0.0351 0.0503 0.0356
Austria 0.1196 0.0025 0.0018 0.0013 0.0530 0.0105 0.0061 0.0043
Belgium 0.0256 0.0026 0.0017 0.0012 0.1197 0.0093 0.0049 0.0033
Canada 0.0040 0.0493 0.0324 0.0194 0.0496 0.0578 0.0361 0.0235
Switzerland 0.1120 0.1282 0.0742 0.0476 0.0441 0.0690 0.0888 0.0658
Germany 0.0002 0.0034 0.0128 0.0144 0.0072 0.0273 0.0258 0.0233
Denmark 0.0278 0.0137 0.0098 0.0059 0.0264 0.0265 0.0145 0.0094
Spain 0.0011 0.0221 0.0244 0.0182 0.0000 0.0000 0.0000 0.0000
Finland 0.1640 0.0353 0.0188 0.0118 0.0000 0.0000 0.0010 0.0015
France 0.0017 0.0667 0.0814 0.0794 0.0000 0.0075 0.0153 0.0297
U.K. 0.0043 0.0073 0.0254 0.0421 0.2426 0.3317 0.2435 0.1553
Hong Kong 0.0009 0.0590 0.0426 0.0308 0.0000 0.0001 0.0016 0.0049
Ireland 0.0139 0.0049 0.0031 0.0021 0.0067 0.0051 0.0055 0.0045
Italy 0.0007 0.0125 0.0193 0.0162 0.0059 0.0128 0.0283 0.0427
Japan 0.0000 0.0014 0.0086 0.0217 0.0585 0.0661 0.0855 0.1078
Netherlands 0.0282 0.0191 0.0119 0.0077 0.0353 0.0119 0.0059 0.0066
Norway 0.0000 0.0059 0.0033 0.0020 0.0000 0.0013 0.0007 0.0005
New Zealand 0.0014 0.0021 0.0015 0.0010 0.0062 0.0020 0.0013 0.0011
Singapore 0.0000 0.0104 0.0084 0.0061 0.0000 0.0022 0.0016 0.0011
Sweden 0.0132 0.0095 0.0107 0.0090 0.0000 0.0000 0.0000 0.0000
U.S.A. 0.1663 0.3830 0.5085 0.5963 0.1845 0.2477 0.3273 0.4374
Sum 0.6859 0.8792 0.9218 0.9475 0.8577 0.9239 0.9438 0.9584
Panel B: Emerging markets
MSR Portfolio MVP
SS SS C OW(10) SS C OW(5) SS C OW(3) SS SS C OW(10) SS C OW(5) SS C OW(3)
Argentina 0.0011 0.0019 0.0010 0.0006 0.0026 0.0015 0.0010 0.0006
Brazil 0.0055 0.0158 0.0138 0.0093 0.0004 0.0008 0.0006 0.0005
Chile 0.1049 0.0112 0.0058 0.0035 0.0290 0.0094 0.0054 0.0040
Greece 0.0065 0.0060 0.0039 0.0029 0.0008 0.0061 0.0062 0.0062
Indonesia 0.0044 0.0034 0.0020 0.0013 0.0017 0.0016 0.0015 0.0010
Korea, S. 0.0600 0.0241 0.0148 0.0095 0.0249 0.0256 0.0190 0.0120
Malaysia 0.0372 0.0232 0.0145 0.0099 0.0347 0.0120 0.0072 0.0054
Mexico 0.0640 0.0216 0.0122 0.0074 0.0031 0.0015 0.0007 0.0005
Philippines 0.0241 0.0030 0.0015 0.0009 0.0071 0.0014 0.0008 0.0006
Portugal 0.0000 0.0003 0.0008 0.0008 0.0216 0.0044 0.0029 0.0020
Thailand 0.0010 0.0071 0.0045 0.0029 0.0000 0.0001 0.0003 0.0005
Turkey 0.0049 0.0026 0.0018 0.0013 0.0067 0.0042 0.0023 0.0015
Taiwan 0.0006 0.0006 0.0016 0.0023 0.0096 0.0077 0.0084 0.0069
Sum 0.3141 0.1208 0.0782 0.0525 0.1423 0.0761 0.0562 0.0416
The average weights of the MSR portfolio and the MVP with various investment constraints for each country over the sample period are reported.

market represented only about 0.35% of world capitalization, and Central/Western Europe are zero for a number of peri-ods.
the average weight is 10.49%. The extreme weights also oc-cur The more restrictive OW constraints “enforce” portfolio
in Austria, Finland, Ireland, South Korea, Mexico, and the weighting to distribute to other second-best mean-variance-
Philippines. As the overweighting investment constraints are efficient markets of large capitalization. The weightings of
included and become more restrictive, the percentage of the those more constrained portfolios are more balanced than the
portfolios on the assets in developing countries decreases. ones of the short-sale-forbidden portfolios.
An overwhelming amount of investments also can be The percentage of the non-zero-weight month in the testing
found in small-cap areas, such as Latin America, Northern period is reported in Table 13.5. On the whole, assets in the
Europe, Southern Europe, and Oceania when only short- developed countries were more likely to be selected in the
selling is considered. On the other hand, the weights for the optimal portfolios with restrictive upper bounds. When
areas of large market value, such as North America
only short-sale was not allowed, three national
13 International Portfolio Management: Theory and Method 231

Table 13.5 Percentage of non-zero portfolio weight

Panel A: Developed countries
MSR portfolio MVP
SS C OW(5) SS C OW(5)
SS SS C OW(10) (%) SS C OW(3) SS SS C OW(10) (%) SS C OW(3)
Australia 2:56 24:36 25:00 25:64 43:59 58:33 64:74 73:08
Austria 14:74 16:67 24:36 29:49 46:79 71:15 82:05 96:15
Belgium 7:05 23:08 29:49 33:33 73:72 78:21 82:05 94:87
Canada 4:49 21:15 25:00 25:00 29:49 30:77 30:77 30:77
Switzerland 42:95 60:26 64:10 67:95 36:54 71:15 89:74 92:31
Germany 0:64 7:05 17:95 23:08 11:54 25:00 29:49 35:90
Denmark 17:31 43:59 59:62 57:69 58:33 81:41 83:33 91:67
Spain 1:92 18:59 26:92 32:05 0:00 0:00 0:00 0:64
Finland 51:28 58:97 60:90 63:46 0:00 0:64 8:33 8:33
France 1:92 19:87 31:41 44:87 0:00 13:46 22:44 39:10
U.K. 5:77 10:26 23:72 33:97 56:41 64:10 65:38 67:31
Hong Kong 5:13 35:26 42:31 51:28 0:00 2:56 8:97 20:51
Ireland 10:26 18:59 23:08 26:28 17:31 21:15 43:59 56:41
Italy 0:64 12:82 24:36 28:21 23:08 50:00 80:77 91:03
Japan 0:00 2:56 4:49 8:33 70:51 78:21 84:62 92:95
Netherlands 25:00 35:90 44:23 46:15 21:15 21:15 21:15 41:67
Norway 0:64 19:23 21:15 21:79 0:00 4:49 5:77 6:41
New Zealand 2:56 21:79 31:41 35:26 19:23 20:51 26:92 36:54
Singapore 0:00 25:64 37:18 44:87 0:00 6:41 7:05 9:62
Sweden 8:97 14:74 28:85 39:74 0:00 0:64 0:00 0:64
U.S.A. 43:59 72:44 82:05 85:26 67:95 75:00 100:00 100:00
Developed Countries 95:51 100:00 100:00 100:00 100:00 100:00 100:00 100:00
Panel B: Emerging markets
MSR portfolio MVP
SS C OW(5) SS C OW(5)
SS SS C OW(10) (%) SS C OW(3) SS SS C OW(10) (%) SS C OW(3)
Argentina 5:77 25:64 26:28 28:85 22:44 22:44 28:85 32:69
Brazil 18:59 43:59 54:49 55:77 5:13 8:33 7:05 5:77
Chile 30:13 51:28 51:92 52:56 44:87 47:44 50:00 60:26
Greece 13:46 24:36 26:92 32:69 7:69 36:54 51:28 73:72
Indonesia 7:69 25:64 30:13 31:41 14:10 18:59 22:44 25:00
Korea, S. 13:46 28:21 35:26 34:62 44:87 43:59 43:59 44:23
Malaysia 14:10 45:51 54:49 59:62 23:08 25:64 30:77 39:10
Mexico 25:64 49:36 52:56 53:21 8:97 7:69 9:62 8:33
Philippines 30:77 36:54 36:54 37:82 13:46 16:67 19:23 23:08
Portugal 0:00 3:85 16:03 26:28 32:05 46:15 58:33 69:23
Thailand 1:28 35:90 43:59 47:44 0:00 1:92 4:49 8:97
Turkey 12:18 19:23 24:36 28:85 28:21 31:41 31:41 33:97
Taiwan 1:92 2:56 7:05 12:18 33:97 39:74 51:92 51:92
Emerging Markets 67:31 86:54 91:03 92:95 98:08 93:59 94:23 99:36
This table reports the percentages of the months of non-zero portfolio weight for the MSR portfolio and the MVP with various investment
constraints for each country during the sample period.

indices (Japan, Singapore, and Portugal) were never selected in MVP. In the most restrictive case, securities in 22 markets
the MSR portfolio, and eight national indices (Spain, Finland, were included in the MSR portfolio and 23 markets in the
France, Hong Kong, Norway, Singapore, Sweden, and MVP for more than 30% of the sample period, respectively.
Thailand) were never selected in the MVP. Furthermore, only Figure 13.4 shows the numbers of national indices
five markets (Switzerland, Finland, U.S.A., Chile, and selected in the optimal portfolios over the sample period.
Portugal) were included in more than 30% of the sample This cross-strategy comparison supports the essentialness of
period. As the overweighting investments are increasingly the upper bounds of portfolio weighting. The time-series
constrained, the securities in any group of countries were more average of market indices for the no-short-selling MSR
frequently included in the MSR portfolio as well as the portfolio is 4.2 and implies, overall, that more than
232 W.-J.P. Chiou and C.-F. Lee

Panel A: MSR Portfolio

Panel B: MVP

Fig. 13.4 Number of selected national indices in the optimal portfolios

80% of the international portfolios are redundant in the 13.7 Conclusion

same month. The inclusion of overweighting constraints ex-
pands the coverage of the optimal portfolios to 9:6 ŒSS C This chapter adds to the current literature by investigating
OW.10/ ; 11:8 ŒSS C OW.5/ , and 13:3 ŒSS C OW.3/ . Al- the impact of weighting bounds on the benefits and asset
though a certain portion of Sharpe ratio benefits are lost due al-location of the globally diversified portfolio. The
to compulsory diversifications, those strategies also empirical results suggest that boundaries of weighting, such
increase the invariance of weighting and benefits, while at as short-sale and overweighting, decrease but not
the same time expanding the assets chosen in the optimal
completely elimi-nate the benefits of global investment.
portfolios. As the upper bounds are increasingly
constrained, the vari-ations in the elements of the optimal Domestic investors in emerging markets, particularly in East
portfolio diminish. A similar conclusion can also be found Asia and Latin Amer-ica, benefit more from international
in the weighting of the MVP. diversification. This find-ing holds even though the global
financial market has be-come increasingly integrated. In
addition, more restrictive
13 International Portfolio Management: Theory and Method 233

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