Publication Type

Journal Article

Version

publishedVersion

Publication Date

9-2010

Abstract

We propose a new investment strategy employing “factor funds” to systematically enhance the mean-variance efficiency of international diversification. Our approach is motivated by the increasing evidence that size (SMB), book-to-market (HML), and momentum (MOM) factors, along with the market factor, adequately describe international stock returns, and by the direct link between investors’ portfolio choice problems and international asset pricing theories and tests. Using data from ten developed countries during the period 1981-2008, we show that the “augmented” optimal portfolio involving local factor funds substantially outperforms the “benchmark” optimal portfolio comprising country market indices only as measured by their portfolio Sharpe ratios. This strongly rejects the intersection hypothesis which posits that the local factor funds do not span investment opportunities beyond what country market indices do. Among the three classes of factor funds, HML funds contribute most to the efficiency gains. In addition, the local version of factor funds outperforms the global factor funds. The added gains from local factor diversification are significant for both in- and out-of-sample periods, and for a realistic range of additional investment costs for factor funds, and remain robust over time.

Keywords

International diversification, Local factors, Factor funds

Discipline

Finance and Financial Management | Portfolio and Security Analysis

Research Areas

Finance

Publication

Management Science

Volume

56

Issue

9

First Page

1500

Last Page

1518

ISSN

0025-1909

Identifier

10.1287/mnsc.1100.1191

Publisher

INFORMS

Comments

Published version made available in SMU repository with permission of INFORMS, 2014, February 28

Additional URL

https://doi.org/10.1287/mnsc.1100.1191

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