international diversification with factor strongfundsstrong - sandy lai.pdfVIP

International Diversification with Factor Funds * Cheol S. Eun, Sandy Lai, Frans A. de Roon, Zhe Zhang 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. JEL Code: G10, G11, G15 Keywords: International diversification, Local factors, Factor funds * Correspondence: Cheol S. Eun, College of Management, Georgia Institute of Technology, Atlanta, GA 30332-0520, USA, email: cheol.eun@; Sandy Lai, Lee Kong Chian School of Business, Singapore Management Univer