International Diversification with Factor Funds

Management Science, Forthcoming

34 Pages Posted: 11 Jun 2010

See all articles by Cheol S. Eun

Cheol S. Eun

Georgia Institute of Technology - Finance Area

Sandy Lai

University of Hong Kong

Frans de Roon

Tilburg University - Department of Finance

Zhe Zhang

Singapore Management University

Date Written: November 28, 2009


We propose a new investment strategy employing “factor funds” to systematically enhance the mean-variance efficiency of international diversification. Our approach is motivated by the increasing evidence that size (SMB), book-to-market (HML), and momentum (MOM) factors, along with the market factor, adequately describe international stock returns, and by the direct link between investors’ portfolio choice problems and international asset pricing theories and tests. Using data from ten developed countries during the period 1981-2008, we show that the “augmented” optimal portfolio involving local factor funds substantially outperforms the “benchmark” optimal portfolio comprising country market indices only as measured by their portfolio Sharpe ratios. This strongly rejects the intersection hypothesis which posits that the local factor funds do not span investment opportunities beyond what country market indices do. Among the three classes of factor funds, HML funds contribute most to the efficiency gains. In addition, the local version of factor funds outperforms the global factor funds. The added gains from local factor diversification are significant for both in- and out-of-sample periods, and for a realistic range of additional investment costs for factor funds, and remain robust over time.

Keywords: International diversification, Local factors, Factor funds

JEL Classification: G10, G11, G15

Suggested Citation

Eun, Cheol S. and Lai, Sandy and de Roon, Frans A. and Zhang, Zhe, International Diversification with Factor Funds (November 28, 2009). Management Science, Forthcoming. Available at SSRN:

Cheol S. Eun

Georgia Institute of Technology - Finance Area ( email )

800 West Peachtree St.
Atlanta, GA 30308
United States

Sandy Lai (Contact Author)

University of Hong Kong ( email )

Faculty of Business and Economics
K.K. Leung Building, Pokfulam Road
Hong Kong, Pokfulam HK
Hong Kong

Frans A. De Roon

Tilburg University - Department of Finance ( email )

P.O. Box 90153
Tilburg, 5000 LE
+31 1 3466 8361/3025 (Phone)
+31 1 3466 2875 (Fax)

Zhe Zhang

Singapore Management University ( email )

Lee Kong Chian School of Business
50 Stamford Road
Singapore, 178899

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