Investments, tenth edition

   Risk and Return: Summary Statistics 

 Illustrations for most of our discussions in the remaining part of this chapter derive 

from a database of country market-index returns. We use 10 years of monthly returns 

over 2002–2011 for 48 non-U.S. country market indexes as well as the U.S. S&P 500. 

This decade stretches from the beginning of the recovery from the bursting of the tech 

bubble in 2001, through the low–interest rate boom period that followed and the ensu-

ing financial crisis of 2008, and, finally, to the beginning of the slow recovery from 

that crisis. 

 Analysis of risky assets typically focuses on  excess  returns over the risk-free rate. This 

alone adds a perplexing aspect to international investing, since the appropriate risk-free 

rate varies around the globe. Rates of return on identical indexes (as well as individual 

assets) will generate different excess returns when safe bonds are denominated in different 

currencies. Although our perspective is U.S.-based, our methodology would serve inves-

tors in any country, yet the numbers may differ when applied to risk-free rates denomi-

nated in other currencies. 

 The tumultuous period we analyze resulted in unexpected low average excess returns, 

primarily in developed markets, while most emerging markets continued unabated growth. 

This fact alone conveys an important lesson. It provides an extreme example of the general 

observation that realized returns are very noisy reflections of investor expectations and 

may not provide accurate forecasts of future returns. Past returns do, however, provide an 

indication of risk, at least for the near future. While the near-efficient market hypothesis 

applies to  expected returns  (to wit: future returns cannot be forecast from past returns), 

it does  not  apply to forecasting risk. Thus our exercise will allow us to demonstrate the 

distinction between what you can and cannot learn from historical returns that evidently 

departed from prior expectations. 

 While active-strategy managers engage in both individual-market asset allocation and 

security selection, we will restrict our international diversification to country market-index 

portfolios, keeping us on the side of an enhanced passive strategy. Nevertheless, our analy-

sis illustrates the essential features of extended active management as well. 

 We begin with an investigation of the characteristics of individual markets and then 

proceed to analyze the benefits of diversification, using portfolios constructed from 

these individual markets. The market capitalization of individual-country indexes can be 

found in  Tables 25.1  and  25.2 , and the aggregated results for the portfolios are shown in 

 Table 25.9A . This table also displays the performance of two types of portfolios: portfo-

lios aggregated from country indexes and regional-index portfolios. The performances of 

individual-country-index  portfolios  are  shown  in   Table 25.9B .    

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 For the aggregated country-index portfolios, we examine a strategy that constructs 

value-weighted portfolios of developed and emerging markets based on market capital-

izations at the beginning of 2002. These portfolios are rebalanced after 5 years, in 2007, 

based on capitalizations at the end of 2006, and held for another 5 years. (Dividends 

are reinvested throughout the 10-year experiment.) Such a strategy is feasible to a large 

degree, since many (although, admittedly, not all) country-index portfolios are investable 

as index funds or ETFs. Because not all country indexes are investable, this hypothetical 

strategy perhaps generates a bit more efficient diversification than is actually possible. 

On the other hand, if actually held, these value-weighted portfolios would automatically 

be rebalanced to value weights continually. In contrast, we rebalance only once after five 

years, which slightly attenuates diversification benefits. On balance, then, we expect these 

hypothesized portfolios to perform about as well as a feasible country-based, passive 

international strategy.