As I’ve mentioned home bias in the previous post, let me quickly touch on the efficacy of global diversification.
I think it’s best summarised by the conclusion of “Idiosyncratic Volatility and Expected Returns at the Global Level” by Mehmet Umutlu¹,
First, the absence of a relation between global portfolio returns and global idiosyncratic volatility indicates that global diversification is effective because global investors do not require a risk premium for bearing global idiosyncratic volatility. The fact that global diversification is effective implies that the returns of global portfolios are still not highly correlated because efficiency of diversification increases with decreasing return correlations, according to modern portfolio theory.
Second, the results for three different sets of globally diversified test assets, obtained through different diversification channels, show that the risk reduction benefits of global diversification can be gained both by diversifying geographically (through investing in local stock market indexes) and by diversifying industrially (through investing in local or global industry indexes).
Finally, there is no global idiosyncratic volatility anomaly, because an active portfolio strategy based on global idiosyncratic volatility does not generate abnormal returns. Although the use of global test assets in active portfolio management helps diversify global idiosyncratic volatility, it also brings portfolio rebalancing costs. Therefore, a passive investment strategy such as investing in a global market portfolio or in ETFs is a more convenient strategy for international investors to diversify away global idiosyncratic volatility.
In sum, the less integrated the global markets, the more effective global diversification across the local stock market indices.
But that’s not all, there are pockets to achieve even greater diversification. While global large cap firms are both traded by global investors and face a more synchronized global macro environment, smaller stocks are much more idiosyncratic; they are often exposed to just a single local economy or niche market that may be at a different part of the cycle and therefore, less prone to global asset allocation changes.
- Mehmet Umutlu, “Idiosyncratic Volatility and Expected Returns at the Global Level.” Financial Analyst Journal, Vol.71, No.6, 2015 CFA Institute.
Commodities rout hits U.K. stocks.