A sufficient condition to reduce the standard deviation of a portfolio by adding an asset is that the beta of the
C H A P T E R
2 5
International
Diversification
901
25
24
23
22
21
20
19
18
17
16
15
14
13
12
10
9
8
7
6
5
4
3
2
1
24
23
22
21
20
19
18
17
16
15
14
13
12
11
10
9
8
7
6
5
4
3
2
1
11
–0.10
0.10
0.30
0.50
0.70
0.90
1.10
1.30
1.50
1.70
Beta on U.S.
0
5
10
15
20
25
Rank
Markets are sorted by beta, from low to high
Developed + World
Emerging
1
Japan
Pakistan
2
Switzerland
Jordan
3
Israel
Morocco
4
New Zealand Sri Lanka
5
Hong Kong
Malaysia
6
U.K.
Philippines
7
U.S.
Egypt
8
Portugal
Chile
9
Singapore
Colombia
10
Denmark
Thailand
11
Canada
Argentina
12
Australia
Czech Republic
13
Italy Peru
14
Belgium
China
15
Spain
Taiwan
16
France
South
Africa
17
Ireland
Indonesia
18
Netherlands
India
19
Austria
Mexico
20
Greece
Russia
21
Finland
Korea
22
Sweden
Hungary
23
Germany
Poland
24
Norway
Brazil
25
Turkey
Rank Developed Emerging
Rank Legend
Figure 25.4
Beta against the U.S. market of developed and emerging markets, 2002–2011
of all countries. This is not to say, however, that an international portfolio with higher vari-
ance would necessarily be inferior. In fact, when a risk-free asset is available, minimum-
variance portfolios are never efficient (they are dominated by the maximum Sharpe ratio,
or tangency, portfolio on the efficient frontier). But, then, the international portfolio must
show a sufficiently larger average return to provide a larger Sharpe ratio.
Comparison between developed and emerging markets’ betas in Figure 25.4 shows that,
in contrast to the picture painted by standard deviation, emerging markets are not meaning-
fully riskier to U.S. investors than developed markets. This is the most important lesson
from this exercise.
Are Average Returns Higher in Emerging Markets?
Figure 25.5 repeats the previous exercise for average excess returns. The graph shows
that emerging markets generally provided higher average returns than developed markets
over the period 2002–2011. The fact that only 2 (developed) of the 49 markets aver-
aged a lower rate than the risk-free alternative is quite unusual given the volatility of
these markets. However, this result is partially due to the weak U.S. dollar over these
years. When measured in local currencies, returns in eight countries, all developed, aver-
aged below U.S. T-bills over the 10-year period. Beyond that, we see that countries with
relatively low betas (e.g., Pakistan) earned higher returns than countries with relatively
high betas, even the highest-beta country, Turkey. Further, average returns in emerging
markets were generally higher than those in developed countries despite the fact that
emerging market betas were not higher, implying that emerging markets provided better
diversification opportunities than developed markets in this period.
We shouldn’t be too surprised by these results. Remember again that the SD of an average esti-
mated over 120 months is approximately SD(10-year average) 5 SD(1-month average)/
"120 .
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902
P A R T V I I
Applied Portfolio Management
Thus, the SD of the 10-year average monthly return for Pakistan would be about .92%, and that of
Turkey about 1.20%. A departure from mean return of one SD in opposite directions for these two
portfolios would span a distance of about 2.12%, while the difference in average returns is only
.21%. The conclusion is one we’ve noted before: We cannot read too much into realized averages
even over periods as long as 10 years.
Instinct calls for estimating alpha or information ratios for individual markets, to see
whether they are distributed around zero. Recall from our discussion of performance eval-
uation in Chapter 18 that, without positive alpha, we cannot conclude that an asset has
shown superior performance on any measure. The information ratio measures the potential
increase in the Sharpe ratio if the country index were to be added in an optimal proportion
to the U.S index.
Figure 25.6 verifies that information ratios in emerging markets were, on the whole,
clearly better than those in developed markets. This is a result of inferior performance of
the eight markets most affected by the financial crisis, all developed countries, and four
stellar emerging market performers. The performance of the other 36 markets cannot be
distinguished in terms of emerging versus developed. Here again, given the high volatili-
ties, finding four outperformers and eight underperformers in a group of 48 countries is not
surprising or significant.
One striking result is the inferior performance of the U.S. We see this in Table 25.9 A:
Although the U.S. has the lowest standard deviation among all countries, it still ranks near
the bottom in terms of the Sharpe ratio. This may be explained by the financial crisis and/
or by the steady decline in the international economic position of the U.S, as reflected
by the steady decline in the value of the dollar.
5
To investigate the latter possibility,
Figure 25.5
Average dollar-denominated excess returns of developed and emerging markets, 2002–2011
–1.0
–0.5
0.0
0.5
1.0
1.5
2.0
2.5
3.0
3.5
0
5
10
15
20
25
A
verage Excess Return (%/month)
Rank
Markets are sorted by average returns, from low to high
25
24
23
22
21
20
19
18
17
16
15
14
13
12
11
10
9
8
7
6
5
4
2
1
24
23
22
21
20
19
18
17
16
15
14
13
12
11
10
9
8
7
6
5
4
3
2
1
Developed + World
Emerging
1
Greece
Taiwan
2
Ireland
Jordan
3
Finland
Malaysia
4
U.S.
Morocco
5
Italy
Poland
6
Japan
Hungary
7
Belgium
Philippines
8
Portugal
Mexico
9
France
Argentina
10
U.K.
Korea
11
Netherlands
China
12
Israel
Chile
13
Germany
Russia
14
Switzerland
India
15
Hong Kong
South Africa
16
Spain
Turkey
17
Austria
Sri Lanka
18
Sweden
Pakistan
19
New Zealand Thailand
20
Denmark
Czech Republic
21
Canada
Brazil
22
Singapore
Egypt
23
Australia
Peru
24
Norway
Indonesia
25
Colombia
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