Do Foreign Stocks Substitute for International Diversification?

Abstract

Using a novel sample of foreign securities available for trade in 42 countries during the last four decades (1979-2018), we characterize the rise in importance of foreign stocks for investors in their host countries and its implications for diversification benefits across industries and countries. We document a substantial increase in the number and the market value of stocks available for trade in markets outside of their home country (i.e., foreign stocks). The availability of foreign stocks in host countries allows domestic investors to increase their international diversification from home by investing in these stocks. We find that this rise in the number of foreign securities has led to the increase in the importance of industry effects relative to country effects on stock returns. Thus, we conclude that including foreign stocks in portfolio investments offers an effective substitute for international diversification, and significantly contributes towards increasing the integration of global markets.

Keywords: International diversication, Country/industry effects, Foreign stocks, Financial integration

JEL Classification: G11, G15, F36, G31