Portfolio diversification effects of trading blocs: The case of NAFTA

This study investigates the evolving nature of North American Free Trade Agreement (NAFTA) stock market interdependencies and their association with diversification gains from the perspective of US investors. The issues are addressed for both short- and long-run interdependencies through correlation of stock market returns and cointegration of stock market prices. The basic findings include: (1) the existence of a long-term relationship (a cointegration relation) which is time-varying and statistically unstable and (2) diversification gains with cointegration not consistently lower than without cointegration. Thus, per-unit-of-risk diversification gains to US investors from NAFTA stock markets are determined by return volatilities, return correlations and domestic market performance. Based on increased return volatilities and return correlations and the very small per-unit-of-risk diversification gains even when the US stock market performs poorly, US investors’ diversification gains have diminished since the implementation of NAFTA.     

The benefits and costs of geographic diversification in banking

We estimate the benefits of geographic diversification within states and across states for bank risk and return for all U.S. bank holding companies from 1994 to 2008, and assess whether such benefits depend on bank size. For small banks, only intrastate diversification increases risk-adjusted returns and reduces default risk while for very large institutions only interstate expansions are beneficial but only in terms of default risk. In all cases the relationship is hump-shaped indicating that at some point, the possible agency costs associated with banks getting wider and more geographically diversified outweigh the benefits. Our results indicate that small banks and very large banks could still benefit from further geographic diversification.     

AN EMPIRICAL STUDY OF THE DIFFUSION PROCESS OF SECURITIES AND PORTFOLIOS

The nature of the stochastic process generating the path of security prices through time plays an important role in dynamic theories of financial economics. An important consideration is the possible dependency of return variances on price levels. Using 55 years of data separated into five-year intervals, this study demonstrates that, in general, security and portfolio variances are dependent on stock price levels and the relationship is a function of portfolio size. The relationship is unstable over time. The results suggest possible detrimental effects of diversification and financial models based on log-normality are questionable.     

Optimal portfolio diversification with a multi-chain regime-switching spillover GARCH model

A multi-chain regime-switching spillover GARCH (MCRSSG) model is proposed for optimal portfolio diversification. MCRSSG specifies the within-regime time-varying correlation via a multi-chain state-dependent spillover factor and quantifies the magnitude of volatility spillovers under different regime combinations. MCRSSG is applied to investigate the diversification benefit of precious metals, crude oil, and financial securities for the Korean stock market at a sector level. The empirical results reveal that the Dow Jones Islamic market US total return index provides the best diversification benefit and MCRSSG exhibits superior effectiveness for risk-adjusted return and reward-to-semivariance ratio.     

Diversification benefits and persistence of US-based global bond funds

This paper examines diversification benefits and performance persistence of 188 US-based global bond funds that survived and were defunct during the period of 1993–2004. Consistent with managed fund literature, global funds underperform broad-based benchmark indexes; however, the underperformance is less than the funds’ expense ratio. The results using both simple and time-varying frameworks suggest that global funds provide higher total return and comparable risk-adjusted return to domestic bond funds. For US investors specializing in domestic bond funds, global funds can enhance return by 0.5–1% per year without increasing risk. Global funds also provide incremental diversification benefits to equity fund investors. The funds exhibit short-run performance persistence, but this is difficult for investors to exploit, especially in long-run. Global funds show no return seasonality during the sample period. On a risk-adjusted basis, larger and newer funds and funds with long maturity and low expense ratio perform well.     

Effects of Corporate Diversification: Evidence From the Property–Liability Insurance Industry

Using a sample of property–liability insurers over the period 1995–2004, we develop and test a model that explains performance as a function of line‐of‐business diversification and other correlates. Our results indicate that undiversified insurers consistently outperform diversified insurers. In terms of accounting performance, we find a diversification penalty of at least 1 percent of return on assets or 2 percent of return on equity. These findings are robust to corrections for potential endogeneity bias, alternative risk measures, alternative diversification measures, and an alternative estimation technique. Using a market‐based performance measure (Tobin's Q) we find that the market applies a significant discount to diversified insurers. The existence of a diversification penalty (and diversification discount) provides strong support for the strategic focus hypothesis. We also find that insurance groups underperform unaffiliated insurers and that stock insurers outperform mutuals.     

Bank activity and funding strategies: The impact on risk and returns

This paper examines the implications of bank activity and short-term funding strategies for bank risk and return using an international sample of 1,334 banks in 101 countries leading up to the 2008 financial crisis. Expansion into noninterest income-generating activities such as trading increases the rate of return on assets, and it could offer some risk diversification benefits at very low levels. Nondeposit, wholesale funding in contrast lowers the rate of return on assets, while it can offer some risk reduction at commonly observed low levels of nondeposit funding. A sizable proportion of banks, however, attract most of their short-term funding in the form of nondeposits at a cost of enhanced bank fragility. Overall, banking strategies that rely prominently on generating noninterest income or attracting nondeposit funding are very risky, consistent with the demise of the US investment banking sector.     

Is Country Diversification better than Industry Diversification?

In this paper, we develop a framework in which one can examine the source of industry and country diversification by examining their underlying return components. We find that the global cash flow factor explains on average 39% of the variation of country cash flows and global discount rates explain 55% of the variation of country discount rates. These are much less than the explanatory power of the two factors over industry cash flow and discount rate variations, which are 72% and 78% respectively. This suggests that global factors are much less important for return components at country level than at the industry level. As a result, both better diversification of expected returns and cash flows across countries determine the larger benefits of country diversification versus industry diversification. Moreover, emerging markets tend to have much smaller co‐movements of both dividends and expected returns with those of the world, suggesting a lower degree of integration with the world goods and financial markets. Our results cast doubt on the prevailing wisdom that country diversification should be replaced by industry diversification.     

On the diversification benefits of commodities from the perspective of euro investors

This paper investigates the diversification contribution of several commodities to a portfolio of traditional assets from the perspective of a euro investor. The approach applied in our analysis has high informational content as it differentiates between the sources of the diversification benefits in a statistically significant way. The results indicate that the diversification contribution varies greatly amongst the different commodities. Industrial metals, agriculturals and livestock contribute to the reduction of risk, while energy and precious metals contribute to both the reduction of the level of risk and to the improvement of return. The differentiation between bull and bear markets reveals that investors can enhance the portfolio performance by changing exposure into individual commodities. Investors can benefit from the diversification gains through financial instruments as the diversification gains hold both in the sample of physical commodity and commodity futures. Overall, the results confirm that commodities are valuable investments from the perspective of diversification.     

The aggregate cost of equity underdiversification

We analyze equity diversification of all retail investors in a country (Denmark). We find that underdiversification is pervasive. We calculate the nationwide aggregate loss due to underdiversification and express it in absolute and expected‐return terms. The aggregate loss is large. We find that investors with low education, low income, and low wealth are more likely to underdiversify. Despite better diversification, the larger fraction of the aggregate loss nevertheless adheres to the top of the income/wealth distribution. Finally, our results indicate that underdiversification arises because investors have limited information about the benefits of diversification.     

The effects of revenue diversification and cross border banking on risk and return of banks in Africa

The paper analyses the implications of revenue diversification and cross-border banking for risk and return. We sample 320 banks across 29 African countries and employ System GMM estimator as a methodological approach to shed further light on the diversification-stability nexus by examining the complex interaction between three key variables: cross-border banking, diversification and bank stability. The results suggest that exploration risk reduces diversification as the level of capital increases when banks cross border to diversify across revenue generating activities. Our analyses further show that, banks in Africa derive absolute benefits from diversification if they cross border and diversify their revenue base concurrently. These results are robust to a range of controls including alternative variable specifications, regulatory environment that bank operate and methodology.     

DETERMINANTS OF AUDIT FEES FOR QUOTED UK COMPANIES

This study reports further evidence as to the determinants of the audit fees paid by quoted companies in the UK. It outlines a framework based on the findings from semi-structured interviews with partners in four large audit firms and the results of previous research, and tests this framework by means of multivariate analysis using 1987 data for a large sample of quoted UK companies. A model explaining 87 per cent of the variation in audit fees is constructed. The principal explanatory variables are found to be auditee size, return on shareholders equity, the number of subsidiaries, the lag between the year end and the date of the audit report, the size of the auditor, a measure of auditee diversification, the ownership structure of the auditee, and whether the auditor was based in London, with the last three being new variables introduced in this study.     

Monthly Pattern and Portfolio Effect on Higher Moments of Stock Returns: Empirical Evidence from Hong Kong

Using a direct test, this paper studies the month-of-the-year effect on the higher moments of six industrial stock indices of the Hong Kong market. We also examine the portfolio effect on skewness and kurtosis across month of the year to see if such an anomaly exists. The empirical results support a weak month-of-the-year effect in higher moments of stock returns. Using a complete sample of all possible combinations for each portfolio size, we show that portfolio effect varies across month of the year for both skewness and kurtosis. In particular, our results show that diversification does not necessarily provide benefits to rational investors when the stock return distribution is non-normal, even though portfolio formation can reduce standard deviation. In June, August and October, diversification across industrial sectors results in a more negatively skewed and leptokurtic return distribution, which is not preferred by investors with risk-aversion. Two (one) possible explanations for the portfolio effect on skewness (kurtosis) are also provided. Our empirical results add new evidence to the existence of anomalies in the Hong Kong stock market. This revised version was published online in August 2006 with corrections to the Cover Date.     

Shareholder Benefits from Corporate International Diversification

This study provides further evidence on the rates of return realized by the shareholders of multinational firms relative to those of purely domestic firms. The results indicate that the risk-adjusted returns realized by the shareholders are identical across the two groups except where the MNC operates in competitive foreign markets. In that case, MNC shareholders experience negative abnormal returns. The study also provides further evidence on the risk-reduction effect of international diversification. The results fail to support the hypothesis that the beta is a convex function of the degree of international involvement. Finally, the paper provides some preliminary evidence on the effect of corporate international diversification on shareholders' returns. It is found that abnormal returns rise by some 18 percent during the 14 months preceding the initial foreign diversification.     

Covariance and correlation stationarity: Experiences from seven Asian emerging markets

Because of the rising interest and the growing importance of the Asian emerging markets in international diversification, this paper examines the covariance and correlation stationarity in stock return relationships among seven Asian emerging markets. This paper also covers the issue of seasonality in stock return co-movements. Empirical results show that because the correlations among them and those with other developed markets are very small, huge gains from diversifying into the seven Asian emerging markets are possible. Results on stationarity indicate that correlation matrices of stock returns are much more stable then the corresponding variance-covariance matrices and that the length of the estimation period seems to have no impact on the stationarity of the correlation matrix. We also found that virtually no seasonality in the correlations exists among the seven Asian emerging markets. However, we did find that during our sample period covariance among stock returns is nonstationary in January. The author thanks an anonymous referee ofFinancial Engineering and the Japanese Markets for the valuable comments on the earlier version of this article.     

Attention allocation and international stock return comovement: Evidence from the Bitcoin market

We employ extreme Bitcoin returns as exogenous shock events to investigate the impact of investor attention allocation on worldwide stock return comovement. We find that (1) these shock events decrease worldwide stock return comovement, (2) there is an asymmetric effect in which a crash shock event has a greater impact on return comovement than a jump shock event, and (3) the impact of these shock events on equity comovement is more pronounced in emerging markets. Our results suggest that identifying extreme Bitcoin returns will benefit portfolio construction. Our results may be of considerable interest to investors, as well as to academics interested in portfolio diversification, asset comovement, and cryptocurrencies.     

International portfolio diversification: a synthesis and an update

This paper provides a synthesis of the existing literature on international portfolio diversification and presents some new results on the subject. We address the question of whether international portfolio diversification is always a reasonable method of reducing the risk of an investment portfolio without negatively affecting its return expectations. Unfortunately, there is still not a simple answer to this question. When ex-post data is examined, potential benefits of international diversification can certainly be detected. However, we also argue that it might be difficult for investors to select an optimal investment strategy ex-ante, when the correlation structure among the international equity is unstable over time. While such findings do not completely rule out the potential benefits of international diversification, they certainly make them more difficult to realize in practice.     

International index funds and the investment portfolio

Financial advisors often recommend that investors diversify their investments internationally and also use mutual funds with the lowest expenses. Recently it has been possible to use both of these strategies by purchasing an international index fund. This study considers international index funds as a means of portfolio diversification. Performance is evaluated using monthly return data on nine international indexes from January 1989 through December 1997. Returns are measured against the S & P 500 index returns. The results of statistical tests suggest that international index investing does not offer superior returns compared to the S & P 500 index but diversification benefits do exist.     

DIVERSIFICATION AND SKEWNESS IN OPTION PORTFOLIOS

Skewness in returns is relevant to option investors. Because options possess positively skewed distributions, the traditional maxim of diversification, which can destroy positive skewness, is not necessarily consistent with investment objectives. The results indicate that the majority of skewness in option portfolios is diversified with a relatively small portfolio size, suggesting a strategy of antidiversification for option investors. Even though the investment performance of options is inferior to stocks on a risk-return basis, the data indicate the suitability of option portfolios in an environment where an investor's utility is measured by the return, risk, and skewness of the return distribution.     

International diversification: A copula approach

The viability of international diversification involves balancing benefits and costs. This balance hinges on the degree of asset dependence. In light of theoretical research linking diversification and dependence, we examine international diversification using two measures of dependence: correlations and copulas. We document several findings. First, dependence has increased over time. Second, we find evidence of asymmetric dependence or downside risk in Latin America, but less in the G5. The results indicate very little downside risk in East Asia. Third, East Asian and Latin American returns exhibit some correlation complexity. Interestingly, the regions with maximal dependence or worst diversification do not command large returns. Our results suggest international limits to diversification. They are also consistent with a possible tradeoff between international diversification and systemic risk.