What Matters in International Equity Diversification?

Abstract

Over the past decade, investors and financial advisors have shown renewed interest in increasing international equity exposure. Investors confront one of two key issues in making decisions on their strategic allocations, depending on the starting point of their portfolios: 1) for a U.S.-only equity portfolio, the issue is which strategies produce the most beneficial international exposure; 2) for a portfolio already with significant international exposure, the issue is what benefits are there in exploring small cap, micro cap, and new frontiers in international equity investing. We use mean-variance spanning and optimization tests of indexes to assess the comparative benefits of competing paths to international diversification of the equity segment of an investor’s portfolio. We find that for investors with a U.S.-only stock segment in their portfolios, any of the international indexes examined substantially improve risk and return characteristics — more evidence that home bias is costly. No clear winners emerge among the indexes, however. For the investor who already has a diversified portfolio of U.S. large and small cap, developed ex-U.S. large cap, and emerging markets large cap, an extension to frontier markets would be beneficial. The additional diversification and return benefits from extending to developed ex-U.S. small and micro cap as well as emerging markets small and micro cap are small.

Keywords: International Diversification, American Depository Receipts, Small-Cap Stocks, Frontier Markets, Emerging Markets, Mean-Variance Spanning, Downside Risk

JEL Classification: G11, G15, G23, C32, C61