Global Asset Allocation and Stock Selection Global Asset

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 Cam. harvey@duke. edu +1 919. 660. 7768 office || +1 919. 271. 8156 mobile http: //www. duke. edu/~charvey 1

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 2

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 Seven Year Treasury STRIP Credit MBS Aggregate Wilshire Small Cap Five Year Treasury STRIP Government Three Year Treasury STRIP Two Year STRIP EAFE One Year Treasury STRIP Source: Erb and Harvey (2004) 3

Returns and Diversification 4 Data from MSCI

Returns and Diversification Data from IFC 5

Returns and Diversification Data from MSCI 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 IFC 10

Returns and Diversification Data from MSCI 11

Returns and Diversification Data from IFC 12

Returns and Diversification Data from IFC and MSCI 13

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

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

What to Expect 19 Source: Goldman Sachs (2002)

What to Expect • Ten-year risk premium around 3. 5% and stable whereas one-year risk premium quite variable 10 -year premium Source: Graham and Harvey (2005) 1 -year premium 20

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

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

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

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

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

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

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

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

Alternative Vehicles Alternate Asset Classes Often Involve Implicit or Explicit Options Source: Naik (2002) 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 35 Source: Figure 5 from Mitchell & Pulvino (2000)

Alternative Vehicles Alternate Asset Classes Often Involve Implicit or Explicit Options 6 4 Event Driven Index Returns 2 0 -15 -10 -5 0 5 10 -2 -4 LOWESS fit -6 -8 Source: Naik (2002) Russell 3000 Index Returns 36

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

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

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: 39

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 40

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 41

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!] 42

Rethinking Risk 43 Source: Harvey and Siddique (2000)

Rethinking Risk Data from MSCI 44

Rethinking Risk Data from IFC 45

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 46

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

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

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

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

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

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

U. S. Has Become a Riskier Global Investment • Equation implies an increase in the mediumterm risk premium of 240 bp – 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) 53

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 54

Readings • All articles on www. duke. edu/~charvey – 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 55