How to Diversify Internationally? A Comparison of Conditional and Unconditional Asset Allocation Methods

Abstract

To obtain the maximum benefits from diversification, financial theory suggests that investors should invest internationally because of the larger potential for risk reduction. The question that we raise in this paper is how to select the optimal portfolio of countries? This article synthesizes the major international asset allocation methods based on mean-variance analysis that have been proposed so far in the literature. In particular it compares two types of conditional asset allocation with unconditional methods. The different policies are simulated in a truly ex-ante framework that reflects exactly the uncertainty faced by the portfolio manager at the moment he has to decide upon his future investments. The asset allocation methods are implemented from a Swiss perspective over the period 1988-2001. We find that conditional methods based on direct predictability of expected returns outperform all other asset allocation methods.