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This paper investigates the relative magnitude of the international diversification benefits for the domestic investors in various countries. The constraints of short-sales, over-weighting investments, and investing region are considered. The empirical results suggest that local investors in the less developed countries, particularly in East Asia and Latin America, comparatively benefit more from both regional and global diversification. This finding holds even though the international market has become more integrated so that the diversification benefits have decreased over the past two decades. The results are useful for asset management professionals to determine target markets to promote the business of national/international funds.

In past years, the meetings of the World Trade Organization (WTO) have caught substantial attention worldwide for not only their agendas but also the aggressive demonstrations against the removal of free-trade barriers among economies. The allegation of protestors is that the wealthy nations take advantage of the less developed countries via pressuring them to liberalize markets. One may be curious about whether this accusation is true, at least in international investment. This paper aims to answer this question by empirically exploring the comparative benefits of international diversification for domestic investors in different countries. The benefits of international diversification have been documented by financial economists over the past four decades. The majority of previous researches investigate strategies and benefits of global diversification from perspective of investors in developed countries, particularly those in the United States.1 A comparison of international diversification benefits to local investors in various countries was not yet explored. Moreover, to ensure the feasibility of strategies, the impact of disproportional asset allocation on the optimal portfolio needs to be taken into account. The answers to the above issues provide critical insights to financial professionals. The countries in which domestic investors receive comparatively higher benefits from international diversification represent target markets for the asset management industry. The evident enhancement of portfolio performance for investors in less developed countries also implies that liberalizing international investment is a win–win policy that allows both domestic and foreign investors to maximize wealth. The analyses of global diversification benefits discussed in this paper are different from previous studies in two dimensions. First, this paper evaluates the benefits of diversification from the local perspective in various countries. International investment is critical for investors in newly developed markets with small asset menus. Second, the infeasibility of strategies produced by extreme asset allocation is considered. Previous researches document that the benefits of international diversification are not entirely eroded by short-sale constraints. However, due to the lack of investibility in certain nations,2 investors may also need to consider the relative magnitudes of market values since they associate to the liquidity of a portfolio. The more constrained optimal portfolios allow international investors to generate more feasible strategies. Previous empirical evidence has confirmed the improvement of mean-variance efficiency via diversifying internationally. De Roon et al. (2001), Harvey (1995), Li et al. (2003), and Pástor and Stambaugh (2000) showed that domestic investors can enhance investment performance by including foreign assets in a portfolio when short-sales are not allowed. Errunza et al. (1999) find that the benefits of international diversification can be duplicated by utilizing domestically traded American Depositary Receipts (ADRs). Green and Hollifield (1992) and Jagannathan and Ma (2003) demonstrate theoretical models and suggest that extreme portfolio weights cast doubt on the practicability of the optimal asset allocation. This paper explicitly links upper weighting boundaries with sizes of international markets while simultaneously considering non-negative weighting. In addition, since investors often prefer to invest in familiar assets as opposed to unfamiliar securities,3 the benefits of the “home-biased” international diversification, or regional diversification, for domestic investors also are evaluated in this paper. There are three reasons that the unattainability of short-sale and extreme weights in international asset allocation need to be taken into account. First, when the portfolio weighting is determined, both the profitability and marketability of investment targets should be taken into account. The centralization of funds in the minor markets recommended by the extreme weights in less-constrained asset allocation strategies may cause illiquidity of the portfolio. Second, the excessive foreign capital in- and out-flows in small markets tend to trigger volatility in asset values. This may generate dramatic alterations in mean-variance efficiencies and correlations in international financial markets. Finally, in many countries, particularly developing countries, governmental regulations prohibit foreign investors to short sell and/or to hold more than a certain proportion of company shares. An extreme percentage of capital allocation to the securities in these markets is legally impractical. Therefore, the results of this paper are more realistic for asset management since illiquidity of portfolio, variation in return and volatility, as well as legal limitations are considered when the optimal portfolio strategies are shaped. To appropriately estimate the gains of international diversification, two straightforward measures, the increase in risk-adjusted premium by investing in the maximum risk-adjusted return (MRR) portfolio and the reduction in the volatility by investing the minimum variance portfolio (MVP) on the international efficient frontiers, are utilized. Additionally, this paper extends the study in diversification benefits by including over-time comparison and cross-region analyses. An increase of correlations and reduction of returns in the global market cast a shadow of doubt on the effectiveness of international diversification.4 An inter-temporal comparison of diversification benefits is helpful to determine the impact of integration of the international financial market. The cross-region examinations help regional investors to determine diversifying complementarity of portfolios in other areas. The empirical results suggest that domestic investors in emerging markets, particularly in East Asia and Latin America, benefit more from international diversification. This result holds for both global and regional portfolios with various investment restrictions and in different sub-periods. It is also found that the global diversification benefits decrease as the world financial market has became more integrated. The cross-continent analysis suggests that the inclusion of securities from European or Latin American countries effectively increases mean-variance efficiency while the addition of North American or European assets reduces portfolio risks for investors in other areas. The paper is organized as follows. Section 2 describes the estimate of the benefits of international diversification. The data used in this study are described in Section 3. Section 4 reports the major empirical results of the international comparison of diversification benefits. The over-time examinations and cross-region analyses are reported in Section 5. Conclusions are presented and relevant issues are discussed in Section 6.

This paper investigates the comparative benefits of international diversification in various countries. The empirical findings suggest that investors in less developed countries, particularly East Asia and Latin America, benefit more than those in developed countries from both regional and global diversifications. This result holds even when various constraints are included and in different sub-periods. The absolute values of gains reduced over time due to the integration and the financial crises of the international financial market. The inclusion of securities in European or Latin American countries, in general, generated the highest upsurge of premiums and the addition of North American or European assets effectively reduces portfolio risks for the investors in other areas. Our analyses of the benefits of international diversification add to the existing literature by at least two contributions. First, the international diversification benefits from a domestic perspective in a large cross-section of countries are assiduously investigated. Second, this paper considers the infeasibility of disproportional asset allocation among international financial markets. The results are useful for professionals of asset management in determining target markets. In addition, since domestic investors in emerging markets obtain comparatively higher international diversification benefits, liberalizing their nationals to invest foreign assets is a win–win policy. The major caveat of this paper is the static allocation of portfolios. Bekaert and Harvey (1995), Bekaert et al. (2005), and De Jong and De Roon (2005) document the temporal variation of the integration of international financial markets. Chan et al. (1999) develop the forecasting model for the covariances. Harvey (1995) also documents the predictability of international equity returns. However, the purpose of the current paper is to investigate the difference of benefits of international diversification among markets with various investment constraints in a long-term. Future researches may apply dynamic asset pricing theory or conditional volatility models and take into account the demands of hedging to market exposure and exchange rates.