international portfolio diversification
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INNOCENTS ABROADInternational Diversification
Andrea GherziLucrezia Grasso Mustafa KhanHeathcliff Lewis
Innocents AbroadInnocents Abroad
Agenda2
Firm’s Strategy Global Equity Markets Performance Correlation Analysis Impact of currency movements Portfolio Allocation
Innocents AbroadInnocents Abroad
Agenda3
Firm’s Strategy Global Equity Markets Performance Correlation Analysis Impact of currency movements Portfolio Allocation
Innocents AbroadInnocents Abroad4
CapGlobal Advisors, LLC
Equities, Fixed Income and FX Portfolio Management
Focus on International Diversification Better risk-return tradeoff Diversifying across nations with different
economic cycles Better returns with lower systematic risk
than domestic portfolios
Innocents AbroadInnocents Abroad
Agenda5
Firm’s Strategy Global Equity Markets Performance Correlation Analysis Impact of currency movements Portfolio Allocation
Innocents AbroadInnocents Abroad
Global Equity Markets Performance66
0
500
1000
1500
2000
2500
3000
3500
D-80 M-82 O-83 M-85 A-86 J-88 J-89 N-90 A-92 S-93 F-95 J-96 N-97 A-99 S-00 F-02 J-03
Market Indices (Local Currency)
Australia
Canada
France
Germany
Hong Kong
Japan
U.K.
U.S.0
500
1000
1500
2000
2500
3000
D-80 A-82 A-84 N-85 J-87 M-89 N-90 J-92 M-94 N-95 J-97 M-99 N-00 J-02
Market Indices (Dollars)
Visible Dotcom bubble Strong U.S. performance
Innocents AbroadInnocents Abroad77
Global Equity Markets Performance
-50%
-40%
-30%
-20%
-10%
0%
10%
20%
30%
Index Returns (Dollars)
-40%
-30%
-20%
-10%
0%
10%
20%
30%
Index Returns (Local Currency)
Australia Canada France Germany Hong Kong Japan U.K. U.S.
Emerging Markets VolatilityCanada highly correlated with Dollar
Innocents AbroadInnocents Abroad8
Global Equity Markets Performance
Australia Canada France Germany Hong Kong Japan U.K. U.S.
Annualized Mean 12.85% 11.59% 15.33% 11.56% 17.58% 6.77% 14.80% 14.05%Std 18.56% 15.52% 20.74% 19.57% 30.69% 19.25% 16.65% 15.53%
Annualized Mean 14.99% 10.22% 18.69% 13.57% 19.03% 14.68% 19.60% 16.54%Std 23.38% 16.25% 22.09% 18.81% 31.98% 19.62% 18.46% 16.02%
Annualized Mean 10.90% 12.85% 12.25% 9.72% 16.24% -0.48% 10.40% 11.77%Std 12.69% 14.87% 19.46% 20.29% 29.57% 18.73% 14.74% 15.08%
1981 - 2003
1981- 1991
1992- 2003
Risk-Return Characteristics (Local Currency)
Innocents AbroadInnocents Abroad9
Global Equity Markets Performance
Australia Canada France Germany Hong Kong Japan U.K. U.S.
Annualized Mean 11.94% 11.57% 14.96% 12.82% 16.08% 10.52% 13.79% 14.05%Std 23.44% 17.82% 21.75% 20.73% 31.64% 23.96% 18.39% 15.53%
Annualized Mean 12.22% 10.83% 18.16% 16.60% 15.88% 20.31% 17.93% 16.54%Std 28.06% 18.12% 24.92% 22.10% 33.84% 25.16% 21.79% 16.02%
Annualized Mean 11.68% 12.25% 12.03% 9.35% 16.27% 1.56% 9.99% 11.77%Std 18.31% 17.61% 18.42% 19.41% 29.60% 22.58% 14.60% 15.08%
1992- 2003
1981- 2003
1981- 1991
Risk-Return Characteristics (Dollars)
Innocents AbroadInnocents Abroad
Agenda10
Firm’s Strategy Global Equity Markets Performance Correlation Analysis Impact of currency movements Portfolio Allocation
Innocents AbroadInnocents Abroad
Correlation Analysis11
Why Correlation is Important? Measure interactions of different
markets
Determine diversification benefits
Correlation between U.S and other Markets
Correlation among International Markets
Innocents AbroadInnocents Abroad
Correlation 1981-2003 Local Currency
Correlation Analysis
Australi
a Canada France Germany
Hong Kong Japan U.K. U.S.
Australia 1
Canada 0.5881 1
France 0.4135 0.5341 1
Germany 0.4288 0.5112 0.7144 1
Hong Kong 0.4720 0.4782 0.3739 0.4483 1
Japan 0.3252 0.3795 0.3986 0.3506 0.2771 1
U.K. 0.5342 0.6317 0.6113 0.5986 0.5430 0.4032 1
U.S. 0.5074 0.7795 0.5910 0.5833 0.4485 0.3799 0.7060 1
Currency Risk?
12
Innocents AbroadInnocents Abroad
Correlation Analysis
Australi
a Canada France Germany
Hong Kong Japan U.K. U.S.
Australia 1
Canada 0.5958 1
France 0.3875 0.4672 1
Germany 0.3778 0.4423 0.7294 1
Hong Kong 0.4713 0.4794 0.3303 0.3903 1
Japan 0.3339 0.3487 0.4108 0.3433 0.2661 1
U.K. 0.5489 0.5892 0.5972 0.5716 0.4819 0.4520 1
U.S. 0.4733 0.7646 0.5226 0.5079 0.4349 0.3253 0.6125 1
Correlation 1981-2003 Dollars13
Innocents AbroadInnocents Abroad
Comparison 1981 - 2003
Lower Correlation Higher Returns VolatilitySimilar Market Risk
Local Currency
Correlation with
U.S
Reutrns Volatility
Beta
Australia 0.5074 18.56% 0.6065
Canada 0.7795 15.52% 0.7791
France 0.5910 20.74% 0.7896
Germany 0.5833 19.57% 0.7353
Hong Kong 0.4485 30.69% 0.8866
Japan 0.3799 19.25% 0.4710
U.K. 0.7060 16.65% 0.7569
U.S. Dollars
Correlation with
U.S
Reutrns Volatility
Beta
Australia 0.4733 23.44% 0.7144
Canada 0.7646 17.82% 0.8778
France 0.5226 21.75% 0.7322
Germany 0.5079 20.73% 0.6780
Hong Kong 0.4349 31.64% 0.8862
Japan 0.3253 23.96% 0.5019
U.K. 0.6125 18.39% 0.7256
Correlation Analysis14
Innocents AbroadInnocents Abroad
Correlation is time varying!
Positive Trend: correlation is increasing in time
1981 – 1991 1992 - 2003
Local
Currency U.S Dollars Local Currency U.S Dollars
Australia 0.4715 0.6197 0.3921 0.6142
Canada 0.7776 0.7859 0.7466 0.7855
France 0.5030 0.6871 0.4263 0.6561
Germany 0.4533 0.7022 0.3603 0.6698
Hong Kong 0.3463 0.5559 0.3287 0.5547
Japan 0.3815 0.3738 0.2819 0.3671
U.K. 0.6904 0.7289 0.5663 0.6981
Correlation Analysis15
Innocents AbroadInnocents Abroad
Correlation Analysis
Correlation with U.S market in Local Currency
D-82D-8
3D-8
4D-8
5D-8
6D-8
7D-8
8D-8
9D-9
0D-9
1D-9
2D-9
3D-9
4D-9
5D-9
6D-9
7D-9
8D-9
9D-0
0D-0
1D-0
2D-0
3
-0.4
-0.2
0.0
0.2
0.4
0.6
0.8
1.0
Australia Canada France Germany Hong Kong Japan
16
Innocents AbroadInnocents Abroad
Correlation AnalysisCorrelation with U.S market in Dollars
-0.4
-0.2
0
0.2
0.4
0.6
0.8
1
Australia Canada France Germany Hong Kong Japan
17
Innocents AbroadInnocents Abroad
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-0.4
-0.2
0
0.2
0.4
0.6
0.8
1
1.2
5%
7%
9%
11%
13%
15%
17%
19%
21%
23%
25%
S&P 500 returns EAFE EAFE $ S&P 500 Volatility
Co
rre
lati
on
Valu
es
Sta
nd
ard
De
via
tio
n
123456789101112131415161718192021222324252627282930313233343536373839404142434445464748495051525354555657585960616263646566676869707172737475767778798081828384858687888990919293949596979899100101102103104105106107108109110111112113114115116117118119120121122123124125126127128129130131132133134135136137138139140141142143144145146147148149150151152153154155156157158159160161162163164165166167168169170171172173174175176177178179180181182183184185186187188189190191192193194195196197198199200201202203204205206207208209210211212213214215216217218219220221222223224225226227228229230231232233234235236237238239240241242243244245246247248249250251252253
-0.4
-0.2
0
0.2
0.4
0.6
0.8
1
1.2
5%
7%
9%
11%
13%
15%
17%
19%
21%
23%
25%
S&P 500 returns EAFE EAFE $ S&P 500 Volatility
Co
rre
lati
on
Valu
es
Sta
nd
ard
De
via
tio
n
Correlation Analysis18
Innocents AbroadInnocents Abroad
Agenda19
Firm’s Strategy Global Equity Markets Performance Correlation Analysis Impact of currency movements Portfolio Allocation
Innocents AbroadInnocents Abroad
Impact of Currency Movements20
1981
1982
1983
1984
1985
1986
1987
1988
1989
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
-40%
-30%
-20%
-10%
0%
10%
20%
30%
40%
50%
60%
Total spread Equity Ret
Innocents AbroadInnocents Abroad
Risks and Mitigation21
Exchange risk Hedge portfolio using forward exchange
contracts, swaps etc Political risks
Exchange rate effects can be hedged
Innocents AbroadInnocents Abroad
Agenda22
Firm’s Strategy Global Equity Markets Performance Correlation Analysis Impact of currency movements Portfolio Allocation
Innocents AbroadInnocents Abroad
International Portfolio Allocation
S&P 500 EAFE $ Return Stdev Return Stdev Return Stdev100% 0% 13.40% 15.51% 15.71% 16.37% 11.29% 14.70%80% 20% 13.04% 14.67% 16.02% 15.28% 10.31% 14.09%60% 40% 12.68% 14.45% 16.33% 15.05% 9.34% 13.86%50% 50% 12.51% 14.59% 16.49% 15.28% 8.86% 13.90%
1981- 2003 1981- 1991 1992 -2003Portfolio Allocation
23
Innocents AbroadInnocents Abroad
International Portfolio Allocation
-30%-25%-20%-15%-10%
-5%0%5%
10%15%20%25%30%35%40%45%
1981
1982
1983
1984
1985
1986
1987
1988
1989
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
US vs International Market Performance YOY
EAFE S&P 500 EAFE $
24
Innocents AbroadInnocents Abroad
International Portfolio Allocation
25
14.00%
16.00%
18.00%
20.00%
22.00%
24.00%
26.00%
28.00%
30.00%
32.00%
34.00%9.00%
10.00%
11.00%
12.00%
13.00%
14.00%
15.00%
16.00%
AustraliaCanada
France
Germany
HK
Japan
UKUS
1981 - 2003
Annualized Standard Deviation
Annualized R
etu
rn
Portfolio Allocation
Australia
Canada
France
Germany
Hong Kong
Japan
U.K.
U.S.