Do Investors Still Benefit from International Diversification With Investment Constraints?

Abstract

The benefits of global diversification have been documented by financial economists over the past four decades. Since the correlations of asset yields across countries are lower than within a country, the volatility of a portfolio's return can be reduced, without sacrificing its expected return, by investing in overseas assets. Due to the lack of investibility of stocks in certain countries, however, investors may not necessarily be able to allocate assets by completely following the unrestricted efficient frontier suggested by Markowitz (1952). Previous studies investigate the strategies of asset allocation and the diversification benefits with short-selling constraints. Yet, the impact of over-weighting investment restrictions on the global diversification benefits remains unclear. Furthermore, while in theory the inclusion of more securities in a portfolio will help to diversify, in practice investors may wish to determine the optimal complementary investing areas in which securities generate the maximum marginal contribution to the portfolio. The answers to these issues provide critical insights for professionals of asset management. This paper empirically explores the potential advantages brought about by international diversification with various investment constraints such as short-selling, over-weighting, and investing regions for U.S. domestic investors. Our finding suggests that adding short-sales and over-weighting constraints reduces but does not eliminate the diversification benefits to the U.S. domestic investor. For cross-regional comparison, the greatest diversification benefits come from adding assets from the Central/West European and Latin American countries. The over-time analyses show that the absolute values of diversification benefits reduce over time as international markets become more integrated. However, the relative values of benefits suggest that international diversification is still desired by the U.S. investor.