International Diversification Benefits: An Investigation from the Perspective of Chinese Investors

Abstract

This paper investigates the potential benefits of international diversification with short-selling constraints from the perspective of Chinese investors. Based on a stream of time-rolling realized portfolios, we show that Chinese investors can gain substantially in terms of portfolio risk reduction as they venture into global markets, regardless of the region into which they choose to diversify and whether in-sample or out-of-sample performance is evaluated. The risk reduction is particularly pronounced when investing in developed and Euro-American markets as compared with a well-diversified domestic portfolio. The in-sample test also demonstrates that international diversification can greatly enhance the expected portfolio returns as well as the risk-adjusted returns. However, Chinese investors cannot achieve higher out-of-sample expected returns and risk-adjusted returns unless they choose to only diversify into emerging markets. In addition, our analysis illustrates that optimal portfolio weights vary significantly over time due to fluctuations in the correlations among international markets, suggesting that international portfolios need to be rebalanced frequently in order to generate the greatest possible diversification benefits.