gains from international portfolio diversification: uk evidence 1971–75
TRANSCRIPT
GAINS FROM INTERNATIONAL PORTFOLIO DIVERSIFICATION: UK EVIDENCE 1971-75
ANTHONY SAUNDERS AND RICHARD S. WOODWARD.
INTRODUCTION
Traditional portfolio theory as developed by Markowitz (9) and Tobin (13) has demonstrated that gains exist from national portfolio diversification. A number of US authors’ have extended and developed this model to show that further gains can (theoretically) and do (empirically) exist when portfolios are internationally diversified. However, since all of these studies encompassed time periods over which exchange rates were generally fixed,? the consequences of exchange rate variability for gains from international portfolio diversification (IPD) have yet to be analysed. Furthermore, whilst the presence of exchange restrictions on foreign investment are usually acknowledged, they have yet to be systematically included in the calculation of these gains.
Since December 1971, UK investors wishmg to buy foreign assets have had to contend with exchange rate variability, in addition to a set of complex exchange restrictions which has created a separate pool of foreign investment currency trading at a premium over the official spot rate. A priori, it might be hypothesised that the above two factors have reduced the returns on and increased risk of international portfolio investment, thereby restricting the gains from IPD.
This study seeks to assess whether the inclusion of these two factors has significantly affected IPD gains for UK investors over the period December 1971 to June 1975. In Part I, the history and operation of the UK investment premium is briefly described and a method of calculating premium adjusted returns presented. In Part 11, a comparison of the unadjusted and the adjusted returns on equity investment in seven major industrial countries is made, and some results are presented which test the optimality of “simple” investment decision rules for UK investors.
Foreign investment by UK residents has been rigorously controlled by the Bank of England since 1947. Investing residents have had to acquire investment currency either directly from other UK residents or from the proceeds of foreign asset sales by other residents. These transactions have established a pool of dollars which trade at a premium over the official (spot) exchange rate3 (see Diagram 1).
‘The authors are lecturers in Economics in the Department of Economics and Banking at the G t y of London Polytechnic. (Paper received July 1976)
Journal of Business Finance & Accounting, 4,3(1977) 299
DIAGRAM 1
Y) 0 Y) 0
r. '0 m 4
2 Y) (?
N N r. 3 N
300 Anthony Saunders and Richard S. Woodward
In April 1965, an additional requirement was introduced by which twenty five per cent of the sales and revenue proceeds of foreign investment had to be surrendered at the spot rate of exchange. This measure amounts to an effective tax on UK foreign asset holdings, since all foreign currency must be purchased at the premium rate, whilst only seventy five per cent can be resold at that rate, which itself may have changed over the investment period.
Two different methods may be used to calculate the investment premium. The first, which expresses the premium relative to a previously fixed spot rate ($2.60/€), has normally been used by brokers to simplify market dealings. The second calculates the premium relative to the ruling spot rate. The latter represents the true cost to UK international investors, and is the method used in this study.
The first step in calculating the returns over the period was to compute a monthly series of capital gains and average dividend yields from equity invest- ment in each country. Following Grubel (S), Solnik (1 1) and Sarnat and Levy (8) amongst others, stock market indices were used to proxy representative equity investment in each country. The seven countries selected were the United Kingdom, Germany, United States, France, Japan, Australia and Canada.
Letting ri refer to unadjusted log returns, we have
r i = l n R i = l n [ I t (
where i = t =
11-1 =
11 = Di = Ri =
Next we adjusted
1, ... 7 refers to country. 1, ... 43 refers to monthly observations from December 197 1 to June 1975. beginning of the month observation on the equity index of country i. end of the month observation on the equity index of country i. average annual dividend yield on equities in country i. 1 + yield on equity holdings defined at any point in time.
these returns for exchange rate variability and the surrender costs awciated with discrete monthly movements into and out of the investment dollar market. Letting *ri refer to these adjusted monthly log returns, we find that
with
Gains from international portfolio diversification: 301
and
X, = 1/[.75(Pt Sg") + .25(Zt SF)] (4)
where Pt- Pt S E SF Z, m
*R',
= $/E premium rate at the beginning of the month. = $/E premium rate at the end of the month. = Foreign cur./$ spot rate at the beginning of the month. = Foreign cur./$ spot rate at the end of the month. = $/E spot rate at the end of the month. = 1, ... 5 referring to the five countries, excluding the UK and
the USA. = adjusted yield on equity holdings defined at any point in time.
I1
Data sources and the monthly adjusted and unadjusted returns over the complete period are listed for comparison in the Appendix. The mean monthly (percent- age) returns and standard deviation have been computed and are presented in Table 1 below.
TABLE 1 ADJUSTED AND UNADJUSTED MONTHLY (%) RATES OF RETURN AND STANDARD DEVIATIONS ON UK AND FOREIGN INVESTMENT
DECEMBER 1971 -JUNE 1975
Rates of Return
Percent per month
Standard f Deviations
Unad- I iusted -0.7
justed Unad- iusted 1.0375
Japan
1.1
1.28
.549
.68 1 1.064
As can be seen from the table above, all returns on foreign investments except UK were reduced once adjustments were made for exchange risk and the investment premium. However, the differences are of such small magnitude that they were lower than a priori expected. Indeed when t-ratios were computed
302 Anthony Saunders and Richard S. Woodward
none were found to be significantly different from zero at the five percent level.
The explanation for this insignificant fall in returns was that each of these foreign currencies experienced almost continuous appreciation with respect to both the pound and the dollar over this period. At the same time the investment dollar-sterling exchange rate showed an increasing premium over the official spot rate (see Diagram I). This implies that UK investors have been compensated for the costs of the investment premium through gains from foreign currency appreciation. For example, the UK investor who went through the investment currency pool (paying a premium) in order to buy German equities often found on realising his investment that the Deutsche Mark had appreciated with respect to the dollar and the (investment) dollar relative to the pound over his investment period. Because of this, it appears that the twenty five percent surrender costs were almost or completely covered.
It can be also seen from Table 1 that the monthly returns are generally low or negative (with the exception of Japan). However, Markowitz (9) - Tobin (13) portfolio theory suggests that these assets might still be included in an efficient portfolio provided that their returns are not highly (positively) correlated with other returns, since by diversification domestic portfolio risk can be reduced. Whilst, ex ante the investor does not know the returns from his foreign invest- ments, if the inter-country correlation between returns are low and stable (that is, there is a degree of stationarity in the international capital market) then a necessary, although not sufficient, condition for IPD exists.
In Table 2 below, the inter-country matrix of correlation coefficients between returns (both unadjusted and adjusted) over the period of analysis, is presented. A comparison of our matrix with those found in past studies4 seems to confirm Solnik’s findings (12, p.50) that “coefficients increase for the time interval used, but not dramatically...”.
Even if the investor expects that these inter-country correlation coefficients will remain stable over the investment period, he must still decide in what proportion to hold assets in different countries. A simple decision rule for the investor would be to divide his international portfolio according to the relative size of each country’s stock market capitalisation. There are, however, two methods of calculating the sterling value of the capitalisation of foreign stock markets; the first is by using the spot rate and the second by the premium rate. Since most investors have to use premium dollars to buy into foreign assets, the latter method might be thought t o be the most appropriate. This has the effect of reducing the relative size of UK assets in an international portfolio, since more sterling would be required per unit of foreign currency.
Gains from international portfolio diversification: 303
TABLE 2 CORRELATION COEFFICIENTS OF UNADJUSTED (ADJUSTED)
RETURNS FOR SEVEN MAJOR COUNTRIES BETWEEN DECEMBER 1971 AND JUNE 1975
I I I I
Canada I I In Table 3 below, two sets of weights are given. The first using December 1971 (beginning of the period) spot rate, and the second (W2), using the same time period's investment currency rate.
was calculated by
TABLE 3 MARKET CAPITALISATION WEIGHTS
DECEMBER 1971
I France I .019 I .02 I I Japan 1 .056 I .06 I I Australia I .008 I .006 I
Source: O.E.C.D. Financial Statistics and The Australian Stock Exchange Official Record.
304 Anthony Saunders and Richard S. Woodward
These weights were then used, with the (average) returns, standard deviations, and the correlation matrix, to calculate the return-risk (standard deviation) combinations the investor would have realised if he had invested in these portfolios.
Spot Weights (w ' 1
TABLE 4 INTERNATIONAL PORTFOLIO RETURN AND RISK DERIVED
FROM THE MARKET CAPITALISATION RULES
Premium Weights (w')
OP 1.03
'P I per cent per month 1 -0.21 I -0.18
0.95
As can be seen from Table 4 above, the portfolio with premium adjusted weights outperforms the unadjusted portfolio and both of these internationally diversified portfolios outperform the UK domestic portfolio (see Table 1). This result implies that there were gains from IPD for UK investors over this time period, and that these gains were present despite the existence of an investment currency premium and exchange rate risk. Obviously these results do not suggest that the market capitalisation rule is optimal, since an investor with knowledge of each countries' realised returns could have improved the performance of this international asset holdings by computing an (ex post) set of efficient portfolios. An efficient portfolio is one that maximises returns given the variance of returns, or minimises the variance, given returns. Using a full covariance matrix method for determining efficient portfolios,6 it was found that the optimal efficiency set consisted of only one, undiversified portfolio, containing Japanese securities.
This result apparently contradicts all previous international portfolio studies which found ex post gains from IPD. However it might be (tentatively) explained by the time period selected for our study.
CONCLUSION
This study attempted to assess whether the coexistence of flexible exchange rates and the investment currency premium had significantly reduced the gains from IPD for UK investors over the period December 1971 to June 1975. A method was presented by which premium costs and exchange rate changes could be incorporated into the calculation of monthly returns on foreign assets. A comparison of these adjusted and unadjusted returns indicated that their
Gains fiom international portfolio diversification: 305
inclusion had only a small net impact since they tended to offset one another.
A simple portfolio strategy was then suggested which demonstrated that gains to UK investors from IPD did exist. Further, these gains were greater when investment currency premiums were taken into account. When the ex post efficient set of portfolios were derived it was found that a single portfolio containing only Japanese securities dominated all others. An attempt was made to reconcile this result with those of previous studies which found that the ex post efficient set of international portfolios were diversified.
NOTES
1 See Adler and Dumas (l) , Agmon (2), Grubel (S), Grubel and Fadner (6), Lessard (7), Levy and Sarnat (8).
2 In one study by Lessard (7), the time period analysed combines observations under both fixed and flexible exchange rate systems.
It must be noted that large institutional investors eg. Investment trusts, can by-pass the investment currency pool through raising foreign (back-to-back) loans. They are required, however, to buy a minimum of 15% of their foreign assets through the currency pool.
See Solnik (12) pp.51-53, where results from five past studies are presented.
Where W1 =
6 The efficient set was found by using the BASIC programme MARKOW. Computations were performed on a Dec-10 system.
REFERENCES
5 Sterling value of stock market i Total sterling value of all stock markets
M. Adler and B. Dumas, “Optimal International Acquisitions”, JOURNAL OF FINANCE 30, N0.1,1975, pp.1-19.
T. Agmon, “The Relations Among Equity Markets: A Study of Share Price Co- movements in the United States. United Kingdom, Germany and Japan”, JOURNAL OF FINANCE 27, N0.4, 1972, pp.839-856.
F. Black, “International Capital Market Equilibrium with Investment Barriers”, JOURNAL OF FINANCIAL ECONOMICS, 1, No.4, 1974, pp.337-352.
S. Gomulka, “Notes on Alternative Growth Strategies For Britain”, unpublished paper, London School of Economics, 1975.
H.G. Grubel, “Internationally Diversified Portfolios: Welfare Gains and Capital FlowS”, AMERICAN ECONOMIC REVIEW 58, N0.5,1968, pp.1229-1314.
H.G. Grubel and K. Fadner, “The Interdependence of International Equity Markets”, JOURNAL OF FINANCE 26, No.l,1971, pp.89-94.
306 Anthony Saunders and Richard S. Woodward
(7) D. Lessard, “World, National and Industry Factors in Equity Returns”, JOURNAL OF FINANCE 29, N0.2,1974, pp.379-391.
(8) H. Levy and M. Sarnat, “International Diversification of Investment Portfolios”, AMERICAN ECONOMIC REVIEW 60, No.3,1970, pp.668475.
H. Markowitz, “Portfolio Selection”, JOURNAL OF FINANCE 7, No.1, 1952, pp. (9) 77-91.
(10) W.F. Sharpe, “Capital Asset Prices: A Theory of Market Equilibrium under Conditions of Risk”, JOURNAL OF FINANCE 19, No.4,1964, pp.425442.
B.H. Solnik, “The International Pricing of Risk: An Empirical Investigation of the World Capital Market Structure”, JOURNAL OF FINANCE 30, No.2, 1975, pp.
(12) B.H. Solnik, EUROPEAN CAPITAL MARKETS: TOWARDS A GENERAL THEORY OF INTERNATIONAL INVESTMENT, Lexington Books, London 1973.
J. Tobin, “Liquidity Preference as Behaviour Towards Risk”, REVIEW OF
(1 1)
365-378.
(1 3) ECONOMIC STUDIES, 26, N0.1,1958, pp.65-86.
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