Lecture 14: Introduction to International and ESG Investing PDF

Longhorn icon Lecture 14: Introduction to International Investing and ESG Investing Concepts primarily from BKM, Ch. 25, 28 John M. Griffin Professor of Finance  International Roadmap The World Market Portfolio – International trends...

Longhorn icon Lecture 14: Introduction to International Investing and ESG Investing Concepts primarily from BKM, Ch. 25, 28 John M. Griffin Professor of Finance  International Roadmap The World Market Portfolio – International trends International diversification – Correlations – Efficient frontiers – Practical Implications… Common Objections to International Diversification – How much weight should we put on them Takeaways International Finance Holdings of Foreign Equities by US Investors  International Investing International investments are rapidly growing throughout world Powerful forces of change: – Free Capital flows Global search for excess returns. – Global deregulation – Growth in equity financing U.S. investors attracted to diversification benefits of equity/bond portfolios There are differences in: – institutions, sources of information, trading methods, reporting as well as the explicit constraints (legal, transaction costs, taxation, political, exchange risk, etc) International Finance  How much? Write down a percent you should invest internationally. Justify it. 6  International Allocations, Are they correct? Company Recommended Foreign Asset Allocation in Overall Portfolio around 2015 MFS Fund Distributors 8% - 30% https://www.mfs.com/wps/FileServerServlet?ar ticleId=templatedata/internet/file/data/sales_too ls/mfsp_20yrsa_fly&servletCommand=default Schwab 5% - 15% http://www.schwab.com/public/schwab/investin g/retirement_and_planning/retirement_income/ portfolio_allocation Vanguard 20%-40% AAII 5% - 30% http://www.aaii.com/asset-allocation?adv=yes http://www.forbes.com/sites/advisor/2012/04/1 Forbes 20% 1/how-much-foreign-portfolio-allocation-is- too-much/2/ Morningstar 20% - 40% http://news.morningstar.com/articlenet/article. aspx?id=540940 Other (news http://www.wsj.com/articles/SB1000142412788 articles, blogs) Around 25% 7323495604578537251459279948 How do banks derive these important numbers?  International Diversification The mere size of foreign markets justifies international diversification for U.S Can we get better diversification by moving money abroad? A. Correlations B. Correlation Implications on the Efficient Frontier International Finance Basic Reasons to Invest Abroad 1. Diversification (For both Passive and Active Investors) – Gives one a less volatile return per unit of risk – Protect against prolonged negative returns. Captures growth potential – With one market one might miss out on extreme upside Capture growth potential 2. It gives more opportunities (For an active investor) – If we could pick the best market (even once in awhile) wouldn’t that be great. Correlations Across Countries from 1991 to 2009 US China Japan HK Korea Canada China 0.27 Japan 0.50 0.14 Hong Kong (HK) 0.60 0.61 0.41 Korea 0.56 0.30 0.57 0.54 Canada 0.81 0.38 0.50 0.65 0.53 Germany (GR) 0.80 0.29 0.43 0.56 0.49 0.73 International Finance  So, more formally, recall… Efficient Portfolios 0.25 For N securities, the Efficient Frontier Expected Return 0.2 problem of identifying efficient 0.15 portfolios is similar, 0.1 except that we need 0.05 special skills in linear 0 programming 0 0.1 0.2 0.3 0.4 0.5 Standard Deviation N N N MIN  = w  i +   wi w j ij 2 2 2 p i i =1 i =1 j =1 i j  subject to E ( R p ) = R p International Finance  Efficient Frontiers of Global and Regional Portfolios Source: Chiou (2006) International Finance  International Diversification There is a big reduction Benefits of Global Diversification in portfolio variance for 100% Total Portfolio Variance as % of Single one that includes foreign 90% 80% and U.S. stocks 70% Stock Variance 60% 50% Portfolio risk falls to 14% 40% 30% of average country’s 20% 10% portfolio variance versus 0% 1 6 11 16 21 26 31 36 41 46 22% for U.S. stocks Number of Stocks alone Within Country Diversification Global Diversification 1 2 N −1  2p = i +  ij N N Source: Griffin & Karolyi, Journal of Financial Economics, 1998 International Finance  International Benefit: Capturing Upside… Would a U.S. only investor miss extreme positive returns? How would an active investor view this? International Finance International Valuation Time Series  Understanding Home Bias Home Bias: In a perfect world, everyone should hold the market portfolio (or close to it) but they don’t. – Why should they hold the world market portfolio? How bad is home bias? Why? 23  Holdings of Foreign Equities by US Investors $6,000.00 30% Holdings of foreign equities by US investors (inludes ADRs) $5,000.00 % of all equity holdings 25% $4,000.00 20% Billions $3,000.00 15% $2,000.00 10% $1,000.00 5% $0.00 0% Source: Federal Reserve Flow of Funds Holdings of Foreign Equities by US Investors  Common Objections to International Diversification 1. International Markets are more Volatile. 2. Currencies add Risk 3. I can get the gains from Markets at Home. o Domestic Securities with International Business 4. International markets move together much more now. 5. Diversification doesn’t work in bad time. 26  Objection 1. International Markets are Riskier, see the volatility? Turkey China Brazil Venezuela Hong Kong Mexico Chile Greece Ireland Thailand Sweden UK South Africa Finland France Singapore Malaysia Netherlands Norway Australia Denmark Switzerland Korea Belgium Italy Austria Philippines Spain Canada US Germany New Zealand Taiwan Poland Japan Portugal Argentina Indonesia 0.0% 2.0% 4.0% 6.0% 8.0% 10.0% 12.0% 14.0% 16.0% 18.0% Is thisInternational the relevantFinance measure of Risk? StD Monthly Mean Return Objection 1. International Markets are Riskier Objection 2. International markets have currency risk…. Can currency risks offset reductions in security risks achieved by international diversification? Assume NOKIA (NOA3.DE) stock trades on the XETRA stock exchange at 20 Euros and current exchange rate is $1.50/Euro. If share increases in value to 21 Euros and dollar depreciates to $1.60/Euro what is the US dollar-denominated return on NOKIA stock for a U.S. investor?  PNOA $ ,1 − P $ NOA , 0   P Euro NOA ,1  P $ Euro,1 − P Euro NOA , 0  P $ NOA , 0  $ R NOA = =   P $ NOA , 0   P Euro NOA , 0  P $ Euro, 0   Currency Effects Note that one can either work in Prices  PNOA $ ,1 − P $ NOA , 0   P Euro NOA ,1  P $ Euro,1 − P Euro NOA , 0  P $ NOA , 0  $ R NOA = =   $ PNOA , 0   PNOA , 0  PEuro, 0 Euro $  Or Returns $ RNOA = (1 + RNOA Euro )  (1 + FX Euro $ ) −1 The change in the currency between two period isFX $ Euro  2. What is Currency Risk? People often use currency risk but what does that mean? Notice an equity position in a particular market consists of implicitly two positions. 1. Equity long position in local currency. 2. Long local currency Investors should consider both of these effects They may only want 1 without 2. What can be done? If 2 systematically moves in the same direction as 1 then it seems riskier? – i.e. If you invest in Brazil does the currency fall when the stock market falls. Objection 3. Multinational Diversification Objection 3: I’m diversified, I invest in multi-nationals “Diversification abroad through U.S. investment” How effective is diversification abroad through U.S. Multi-national diversification? Objection 4. The Benefits to International Diversification have diminished over time… Source: Goetzmann, Li, and Rouwenhorst 2003 Core markets—UK, US, France, Germany International Finance  4. Are the benefits of international diversification decreasing? 1980 – 2009 Monthly US CHINA GERMANY FRANCE HK JAPAN KOREA UK US 1.00 CHINA 0.05 1.00 GERMANY 0.81 -0.04 1.00 FRANCE 0.78 -0.03 0.92 1.00 HONG KONG 0.63 -0.01 0.58 0.56 1.00 JAPAN 0.50 0.10 0.46 0.50 0.48 1.00 KOREA 0.56 0.13 0.50 0.50 0.55 0.59 1.00 UK 0.84 0.03 0.85 0.87 0.65 0.52 0.53 1.00 2000 – 2009 Monthly US CHINA GERMANY FRANCE HK JAPAN KOREA UK US 1.00 CHINA 0.01 1.00 GERMANY 0.85 0.04 1.00 FRANCE 0.84 0.03 0.97 1.00 HONG KONG 0.69 0.08 0.73 0.73 1.00 JAPAN 0.57 0.05 0.54 0.57 0.56 1.00 KOREA 0.74 0.13 0.70 0.66 0.69 0.57 1.00 UK 0.87 0.01 0.88 0.91 0.78 0.58 0.69 1.00 International Finance  4. Are the benefits of international diversification decreasing? 2006 – 2009 Monthly US CHINA GERMANY FRANCE HK JAPAN KOREA UK US 1.00 CHINA 0.04 1.00 GERMANY 0.92 0.00 1.00 FRANCE 0.93 0.02 0.98 1.00 HONG KONG 0.66 0.08 0.76 0.76 1.00 JAPAN 0.68 0.09 0.76 0.78 0.69 1.00 KOREA 0.79 0.25 0.85 0.81 0.75 0.74 1.00 UK 0.91 0.05 0.93 0.94 0.83 0.75 0.83 1.00 International Finance Objection 5. Diversification doesn’t work in down periods… World Equity Market Cap 70 65 Trillions 60 55 Gained back $18 trillion (62%) 50 45 Lost $37 trillion (59%!) 40 35 30 25 20 The total market capitalization of all publicly traded companies in the world was US$51.2 trillion in January 2007 and peaked at US$62.5 trillion in October 2007. In early March 2008, global equity markets fell $37 trillion to $25.5 trillion. The value of all public companies worldwide fell 59%! (Data from World Federation of Exchanges)  6. What is the best way to Diversify Internationally? ⚫ When we diversify internationally, we often do so through stocks like Ishares. ⚫ But these have less diversification benefits →Diversification is now less than it was because many international investors have seen the same charts. →Implication: Investors may need to consider investing in smaller, less scrutinized securities. Problem: these have higher transactions costs.  What Affect does Foreign Ownership (FO) have? Global Portfolio Diversification 100% Portfolio varariance as a % of the average 80% 60% stock variance FO=0% 0%