Country ETFs, currencies and international diversification

Abstract

Empirical evidence shows that market prices of country exchange traded funds (ETFs) react in unison with domestic stocks on their listing exchange to a common set of risk factors. This would argue against the use of indirect foreign investments via country ETFs to diversify a portfolio of domestic stocks. Using the net asset values of a cross-section of US and European-listed ETFs to control for market noise and time zone discrepancies, this study seeks to quantify the diversification benefits of country ETFs for a domestic investor. Moreover, fund returns are decomposed into their two fundamental drivers – the variations of the underlying foreign stocks and the foreign currency – in order to investigate the role of currency returns in modifying correlations between country funds and domestic stocks. To conclude, the analysis is repeated for the pre- and post-financial crisis periods to gain insight into shifts in the relationships between world equity markets since this dislocation.