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International Diversification with Factor Funds

Author

Listed:
  • Cheol S. Eun

    () (College of Management, Georgia Institute of Technology, Atlanta, Georgia 30332)

  • Sandy Lai

    () (Lee Kong Chian School of Business, Singapore Management University, Singapore 178899)

  • Frans A. de Roon

    () (Department of Finance and CentER, Tilburg University, 5000 LE Tilburg, The Netherlands)

  • Zhe Zhang

    () (Lee Kong Chian School of Business, Singapore Management University, Singapore 178899)

Abstract

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 10 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-sample and out-of-sample periods, and for a realistic range of additional investment costs for factor funds, and remain robust over time.

Suggested Citation

  • Cheol S. Eun & Sandy Lai & Frans A. de Roon & Zhe Zhang, 2010. "International Diversification with Factor Funds," Management Science, INFORMS, vol. 56(9), pages 1500-1518, September.
  • Handle: RePEc:inm:ormnsc:v:56:y:2010:i:9:p:1500-1518
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    File URL: http://dx.doi.org/10.1287/mnsc.1100.1191
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    References listed on IDEAS

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    Cited by:

    1. Fink, Christopher & Raatz, Katharina & Weigert, Florian, 2014. "Do Mutual Funds Outperform During Recessions? International (Counter-) Evidence," Working Papers on Finance 1415, University of St. Gallen, School of Finance.
    2. Kroencke, Tim A. & Schindler, Felix, 2012. "International diversification with securitized real estate and the veiling glare from currency risk," Journal of International Money and Finance, Elsevier, vol. 31(7), pages 1851-1866.
    3. Hau, Harald & Lai, Sandy, 2013. "Real effects of stock underpricing," Journal of Financial Economics, Elsevier, vol. 108(2), pages 392-408.
    4. Hau, Harald & Lai, Sandy, 2016. "Asset allocation and monetary policy: Evidence from the eurozone," Journal of Financial Economics, Elsevier, vol. 120(2), pages 309-329.
    5. Ephraim Clark & Konstantinos Kassimatis, 2013. "International equity flows, marginal conditional stochastic dominance and diversification," Review of Quantitative Finance and Accounting, Springer, vol. 40(2), pages 251-271, February.
    6. Fathi Abid & Pui Lam Leung & Mourad Mroua & Wing Keung Wong, 2014. "International Diversification Versus Domestic Diversification: Mean-Variance Portfolio Optimization and Stochastic Dominance Approaches," Journal of Risk and Financial Management, MDPI, Open Access Journal, vol. 7(2), pages 1-22, May.
    7. Marshall, Ben R. & Nguyen, Nhut H. & Visaltanachoti, Nuttawat, 2015. "Frontier market transaction costs and diversification," Journal of Financial Markets, Elsevier, vol. 24(C), pages 1-24.
    8. Harald HAU & Sandy LAI, "undated". "The Role of Equity Funds in the Financial Crisis Propagation," Swiss Finance Institute Research Paper Series 11-35, Swiss Finance Institute.
    9. Timotheos Angelidis & Nikolaos Tessaromatis, 2014. "Global portfolio management under state dependent multiple risk premia," Proceedings of Economics and Finance Conferences 0400966, International Institute of Social and Economic Sciences.

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