International diversification with factor funds

C. Eun, S. Lai, F.A. de Roon, Z. Zang

Research output: Contribution to journalArticleScientificpeer-review

Abstract

We propose a new investment strategy employing “factor funds” to systematically enhance the meanvariance 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 10 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-sample and out-of-sample periods, and for a realistic range of additional investment costs for factor funds, and remain robust over time.
Original languageEnglish
Pages (from-to)1500-1518
JournalManagement Science
Volume56
Issue number9
Publication statusPublished - 2010

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International diversification
Factors
Optimal portfolio
Market index
Investment opportunities
Benchmark
Sharpe ratio
Investors
International asset pricing
Investment strategy
Diversification
Book-to-market
Efficiency gains
Market factors
Portfolio choice
International stock returns
Costs
Momentum
Developed countries

Cite this

Eun, C., Lai, S., de Roon, F. A., & Zang, Z. (2010). International diversification with factor funds. Management Science, 56(9), 1500-1518.
Eun, C. ; Lai, S. ; de Roon, F.A. ; Zang, Z. / International diversification with factor funds. In: Management Science. 2010 ; Vol. 56, No. 9. pp. 1500-1518.
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Eun, C, Lai, S, de Roon, FA & Zang, Z 2010, 'International diversification with factor funds', Management Science, vol. 56, no. 9, pp. 1500-1518.

International diversification with factor funds. / Eun, C.; Lai, S.; de Roon, F.A.; Zang, Z.

In: Management Science, Vol. 56, No. 9, 2010, p. 1500-1518.

Research output: Contribution to journalArticleScientificpeer-review

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AU - Eun, C.

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AU - de Roon, F.A.

AU - Zang, Z.

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AB - We propose a new investment strategy employing “factor funds” to systematically enhance the meanvariance 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 10 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-sample and out-of-sample periods, and for a realistic range of additional investment costs for factor funds, and remain robust over time.

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