1. Global Asset Allocation: The Case For International Investment
Global Asset Allocation and Stock Selection
Global Asset Allocation: The Case For International Investment
Campbell R. Harvey
Duke University, Durham, NC USA
National Bureau of Economic Research, Cambridge MA USA
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2. The Plan International track record Returns and diversification
Long horizon vs. short horizon
What can we expect from U.S. equities?
What to expect from international?
Alternative views: dynamic strategies, hedge funds
Research frontier – changing views of diversification
Importance of GPR

3. The International Track Record
U.S. Investments Versus Non-U.S. Equities
Wilshire Mid Cap
Thirty Year Treasury STRIP
Twenty Year Treasury STRIP
Wilshire Large Cap
Wilshire 5000
Ten Year Treasury STRIP
EAFE X-Japan
Wilshire Small Cap
Seven Year Treasury STRIP
MBS
Credit
Five Year Treasury STRIP
Aggregate
Government
EAFE
Three Year Treasury STRIP
Two Year STRIP
One Year Treasury STRIP
Source: Erb and Harvey (2004)

4. Returns and Diversification
Data from MSCI

5. Returns and Diversification
Data from IFC

6. Returns and Diversification
Data from MSCI

7. Returns and Diversification
Data from MSCI

8. Returns and Diversification
Data from MSCI

9. Returns and Diversification
Data from MSCI

10. Returns and Diversification
Data from IFC

11. Returns and Diversification
Data from MSCI

12. Returns and Diversification
Data from IFC

13. Returns and Diversification
Data from IFC and MSCI

14. The Long Horizon
Data from Dimson, Marsh and Stauton (2002)

15. The Long Horizon
Data from Dimson, Marsh and Stauton (2002)

16. The Long Horizon
Data from Dimson, Marsh and Stauton (2002)

17. The Long Horizon
Data from Dimson, Marsh and Stauton (2002)

18. What to Expect
Data from Dimson, Marsh and Stauton (2002)

19. What to Expect
Source: Goldman Sachs (2002)

20. What to Expect
Ten-year risk premium around 3.5% and stable whereas one-year risk premium quite variable
10-year premium
1-year premium
Source: Graham and Harvey (2005)

21. What to Expect U.S. Equity and Bond Returns are Positively Correlated
Source: Erb and Harvey (2004)

22. What to Expect
World Real Equity and Real Bond Returns are Positively Correlated
Source: Erb and Harvey (2004)

23. What to Expect Inflation Negatively Related to Real Bill Returns
Source: Erb and Harvey (2004)

24. What to Expect
Inflation Negatively Related to Real Intermediate Bond Returns
Source: Erb and Harvey (2004)

25. What to Expect Inflation Negatively Related to Real Bond Returns
Source: Erb and Harvey (2004)

26. What to Expect Inflation Negatively Related to Real Equity Returns
Source: Erb and Harvey (2004)

27. What to Expect
Inflation Negatively Related to Real International Bill Returns
Source: Erb and Harvey (2004)

28. What to Expect
Inflation Negatively Related to Real International Bill Returns
Source: Erb and Harvey (2004)

29. What to Expect
Inflation Negatively Related to Real International Equity Returns
Source: Erb and Harvey (2004)

30. What to Expect
Inflation Negatively Related to Real International Equity Returns
Source: Erb and Harvey (2004)

31. Alternative Vehicles
Alternate Asset Classes Often Involve Implicit or Explicit Options
Source: Naik (2002)

32. Alternative Vehicles
Alternate Asset Classes Often Involve Implicit or Explicit Options
Source: Naik (2002)

33. Alternative Vehicles
Alternate Asset Classes Often Involve Implicit or Explicit Options
Source: Naik (2002)

34. Alternative Vehicles
Alternate Asset Classes Often Involve Implicit or Explicit Options
Source: Naik (2002)

35. Alternative Vehicles
Alternate Asset Classes Often Involve Implicit or Explicit Options
Source: Figure 5 from Mitchell & Pulvino (2000)

36. Alternative Vehicles
Alternate Asset Classes Often Involve Implicit or Explicit Options 6 4 2
Event Driven Index Returns
-15
-10 -5 5 10 -2 -4
LOWESS fit -6 -8
Source: Naik (2002)
Russell 3000 Index Returns

37. Rethinking Risk
Traditional models maximize expected returns for some level of volatility
Is volatility a complete measure of risk?

38. Rethinking Risk
Much interest in downside risk, asymmetric volatility, semi-variance, extreme value analysis, regime-switching, jump processes, ...

39. Rethinking Risk
... These are just terms that describe the skewness in returns distributions.
Most asset allocation work operates in two dimensions: mean and variance -- but skew is important for investors.
Examples:

40. Rethinking Risk
1. The $1 lottery ticket. The expected value is $0.45 (hence a -55%) expected return.
Why is price so high?
Lottery delivers positive skew, people like positive skew and are willing to pay a premium

41. 2. High implied vol in out of the money OEX put options.
Rethinking Risk
2. High implied vol in out of the money OEX put options.
Why is price so high?
Option limits downside (reduces negative skew).
Investors are willing to pay a premium for assets that reduce negative skew

42. 3. Some stocks that trade with seemingly “too high” P/E multiples
Rethinking Risk
3. Some stocks that trade with seemingly “too high” P/E multiples
Why is price so high?
Enormous upside potential (some of which is not well understood)
Investors are willing to pay a premium for assets that produce positive skew
[Note: Expected returns could be small or negative!]

43. Rethinking Risk
Source: Harvey and Siddique (2000)

44. Rethinking Risk
Data from MSCI

45. Rethinking Risk
Data from IFC

46. U.S. Has Become a Riskier Global Investment
The U.S. has become much more risky
High sensitivity to some GPRs
Disagreement on strength of economy
Financial information less credible
These factors suggest shifting exposures from equity to safer fixed income

47. U.S. Has Become a Riskier Global Investment
ICRG
Political Risk
Data from PRS

48. U.S. Has Become a Riskier Global Investment
ICRG
Political Risk
Data from PRS

49. U.S. Has Become a Riskier Global Investment
ICRG
Political Risk
Data from PRS

50. U.S. Has Become a Riskier Global Investment
Risk Ratings December 2002
Data from PRS

51. U.S. Has Become a Riskier Global Investment
Risk Ratings May 2001
Data from PRS

52. U.S. Has Become a Riskier Global Investment
Higher risk means equity investors require a higher rate of return
Risk Ratings from Institutional Investor

53. U.S. Has Become a Riskier Global Investment
Equation implies an increase in the medium-term risk premium of 240bp
This helps explain the recent decline in the equity market
This helps explain the recent behavior of the U.S. dollar
This helps explain the slow down in real investment (hurdle rates are up)

54. Conclusions
International investment is mainly about returns – diversification, while important, is often “oversold”
Expected returns depend on fundamental values today – not just historical return performance.
U.S. risk has increased suggesting a reallocation from equity to fixed income

55. All articles on www.duke.edu/~charvey
Readings
All articles on
The Drivers of Expected Returns in International Markets (2000)
Global Tactical Asset Allocation (2001) with Magnus Dahlquist
The Term Structure of Equity Risk Premia (2004) with Claude Erb