The Size and Source of Gains from International Diversification

November 2010

This paper introduces two economically meaningful measures of the gains from international equity diversification and applies them to developed and emerging markets. A long-standing puzzle in finance is that investors hold mostly domestic securities even though access to foreign markets is widely believed to offer large diversification benefits. The paper argues that the usual way of framing this “home-bias puzzle,” in terms of differences in portfolio weights, does not map cleanly onto investor welfare. Instead it proposes two measures that have clear economic meaning and, importantly, do not depend on the currency or on whether returns are real or nominal: the certainty-equivalent wealth gain an investor would accept in exchange for costless access to a foreign market, and the threshold transaction cost that would lead an investor to hold no foreign assets at all. Applying these measures to sector indices for six developed markets and country indices for fourteen emerging markets, the paper reconciles two facts that seem to conflict: the gains from costless access to foreign developed markets are large, yet even small trading costs can rationally justify the observed home bias. It is written for a technical audience of researchers, allocators, and quantitatively minded investors

What This Paper Examines

• Two economically meaningful, unit-free measures of the gains from international diversification.
• How large the gains from costless access to foreign developed and emerging markets are, for investors with different levels of risk aversion.
• What level of transaction costs would lead an investor to hold only domestic assets, and whether that can explain home bias.
• How much of the diversification gain comes from currency exposure rather than the underlying equities.

Key Findings

• Costless access to foreign developed markets offers large welfare gains. Investors would build leveraged, long-short portfolios to capture them. This confirms that, when trading is free, the home-bias puzzle is associated with real economic losses.
• Modest transaction costs can eliminate those gains and rationalize home bias. Because the gains require large positions, even small proportional trading costs make them prohibitively expensive, so investors voluntarily forgo foreign assets. The threshold costs implied by the data are surprisingly low.
• Emerging markets offer smaller gains than commonly believed. Despite their high average returns and low correlations with developed markets, emerging-market country indices are nearly redundant once an investor already holds developed-market assets.
• Less risk-averse investors gain more, not less. Contrary to the intuition that diversification helps mainly by reducing risk, the gains come from exploiting the higher Sharpe ratios of larger markets, so investors who are more willing to bear risk capture larger gains.
• Currency effects explain only a small part of the gains. By isolating pure currency risk through local risk-free rates, the paper shows that exchange-rate exposure accounts for only a small fraction of the total diversification gain.

The Authors

This paper is part of the long lineage of quantitative research that Versor’s founders began earlier in their careers and continue to build on at the firm today.

Ludger Hentschel, Founding Partner, Investment Advisor

Ludger Hentschel joined Versor Investments as a Founding Partner and is based in New York. Ludger has over 20 years of experience in quantitative research and investing.

Versor’s founders co-authored this research with John B. Long Jr., a colleague at the firm where this work was originally conducted.

Disclaimer: Past performance is not necessarily indicative of future results. Not an offer to sell or a solicitation of any type with respect to any securities or financial products.

Methodology: The paper develops two unit-free measures. The first is the certainty-equivalent wealth gain for a log-utility investor, whose optimal portfolio, the numeraire portfolio, is invariant to currency and to real-versus-nominal choices. The second is the threshold proportional transaction cost that drives an investor’s optimal foreign position to zero, expressed through numeraire-denominated excess returns. Both are shown to be independent of the units in which returns are measured, which addresses a known weakness of mean-variance measures.

The measures are applied to weekly returns from January 1989 to July 2004 on ten industry-sector indices plus one-month eurocurrency deposits for each of six developed markets (the United States, Canada, the United Kingdom, Germany, France, and Japan), together with country-level equity indices for fourteen emerging markets in Latin America and Asia. Inference uses Newey-West and GMM methods, and the analysis separates country from currency effects by including each market’s local risk-free rate among the available assets.