International portfolio allocation: The role of conditional higher moments

Abstract

I explore the benefits of incorporating conditional higher moments in the international portfolio allocation. The quantile-based conditional higher moments are robust to outliers and exhibit considerable time-variation and heterogeneity across countries. My empirical evidence shows that emerging market returns have favourable conditional skewness but are more exposed to extreme returns with higher kurtosis. In the international portfolio, the investor tilts her portfolio towards countries with higher skewness and less kurtosis, consistent with her moment preference in theory. An investor with moderate risk aversion would be willing to pay 210 basis points per year to switch from a three-moment portfolio to the portfolio that employs both conditional skewness and kurtosis. The portfolio policy is robust to real-time investing strategy and incorporating transaction costs, but the optimised portfolios underperform the naive value-weighted portfolio out-of-sample.