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Regional indexes
around the crash,
October 14“October 1
26, 1987
Source: From Richard Roll,
“The International Crash of
October 1987,” Financial
Analysts Journal,
September“October 1988.
Copyright 1998, Association Symbols positioned
for Investment Management at market close
and Research. Reproduced local time
and republished from North America
Financial Analysts Journal Ireland, So. Africa, U.K.
with permission from the Large Europe
Small Europe
Association for Investment
Management and Research.
0.7 Australia/New Zealand
All Rights Reserved.

12 14 16 18 20 22 24 26
Tick marks on October date, 4:00 PM, U.S. eastern standard time

macroeconomic shock would affect all countries and that diversification can only mitigate
country-specific events. Our best guess is that the diversification benefits shown by the world
CAPM model are realistic.
Bodie’Kane’Marcus: VI. Active Investment 21. International Investing © The McGraw’Hill
Essentials of Investments, Management Companies, 2003
Fifth Edition

21 International Investing

The benefits from international diversification may be modest for passive investors but for ac-
tive managers international investing offers greater opportunities. International investing calls
for specialization in additional fields of analysis: currency, country and worldwide industry, as
well as a greater universe for stock selection.

Constructing a Benchmark Portfolio of Foreign Assets
Active international investing, as well as passive, requires a benchmark portfolio (the bogey).
One widely used index of non-U.S. stocks is the European, Australian, Far East (EAFE) European,
index computed by Morgan Stanley. Additional indexes of world equity performance are Australian, Far
published by Capital International Indices, Salomon Brothers, Credit Suisse First Boston, and East (EAFE) index
Goldman Sachs. Portfolios designed to mirror or even replicate the country, currency, and A widely used index
company representation of these indexes would be the obvious generalization of the purely of non-U.S. stocks
domestic passive equity strategy. computed by
Morgan Stanley.
An issue that sometimes arises in the international context is the appropriateness of market-
capitalization weighting schemes in the construction of international indexes. Capitalization
weighting is far and away the most common approach. However, some argue that it might not
be the best weighting scheme in an international context. This is in part because different
countries have differing proportions of their corporate sector organized as publicly traded
Table 21.13 shows 1996 and 2001 data for market capitalization weights versus the GDP
for countries in the EAFE index. As in Table 21.13, these data reveal substantial disparities be-
tween the relative sizes of market capitalization and GDP. Since market capitalization is a
stock figure (the value of equity at one point in time), while GDP is a flow figure (production
of goods and services during the entire year), we expect capitalization to be more volatile and
the relative shares to be more variable over time. Some discrepancies are persistent, however.
For example, the U.K.™s share of capitalization is about double its share of GDP, while Ger-
many™s share of capitalization is much less than its share of GDP. These disparities indicate
that a greater proportion of economic activity is conducted by incorporated business in the
U.K. than in Germany. Table 21.13 also illustrates the influence of stock market volatility on
market-capitalization weighting schemes. For example, as its stock market swooned in the
1990s, Japan™s share of EAFE capitalization declined from 44%, more than its share of GDP
in 1996 to 26%, below its share of GDP in 2001.
Some argue that it would be more appropriate to weight international indexes by GDP
rather than market capitalization. The justification for this view is that an internationally di-
versified portfolio should purchase shares in proportion to the broad asset base of each
country, and GDP might be a better measure of the importance of a country in the inter-
national economy than the value of its outstanding stocks. Others have even suggested
weights proportional to the import share of various countries. The argument is that investors
who wish to hedge the price of imported goods might choose to hold securities in foreign
firms in proportion to the goods imported from those countries. The nearby box consid-
ers the question of global asset allocation for investors seeking effective international
Bodie’Kane’Marcus: VI. Active Investment 21. International Investing © The McGraw’Hill
Essentials of Investments, Management Companies, 2003
Fifth Edition

746 Part SIX Active Investment Management

TA B L E 21.13
Weighting schemes for EAFE countries

2001 1996

% of EAFE Market % of EAFE Market
Country Capitalization % of EAFE GDP Capitalization % of EAFE GDP

Japan 25.8 31.0 43.5 31.5
United Kingdom 19.6 10.6 15.5 8.0
Germany 7.9 13.8 6.3 16.0
France 9.8 9.8 5.6 10.4
Netherlands 5.0 2.8 4.4 2.8
Switzerland 5.5 1.8 3.9 2.0
Hong Kong 4.7 1.2 3.8 1.0
Australia 3.2 2.7 2.8 2.7
Italy 5.0 8.1 2.7 8.3
Taiwan 1.7 2.1 2.0 1.9
Spain 2.9 4.3 1.9 4.1
Sweden 1.9 1.6 1.8 1.8
Singapore 1.0 0.6 1.7 0.6
Belgium 1.2 1.7 1.1 1.8
Denmark 0.8 1.2 0.6 1.2
Finland 1.4 0.9 0.5 0.9
Norway 0.6 1.2 0.4 1.1
New Zealand 0.2 0.4 0.4 0.4
Ireland 0.7 0.8 0.3 0.5
Austria 0.2 1.4 0.3 1.5
Portugal 0.4 0.8 0.3 0.8
Greece 0.5 0.9 0.2 0.8
Luxemburg 0.2 0.1 0.1 0.1

Source: Datastream.

Performance Attribution
We can measure the contribution of each of these factors following a manner similar to the
performance attribution techniques introduced in Chapter 20.
1. Currency selection measures the contribution to total portfolio performance attributable
currency selection
to exchange rate fluctuations relative to the investor™s benchmark currency, which we
Asset allocation in
will take to be the U.S. dollar. We might use a benchmark like the EAFE index to
which the investor
compare a portfolio™s currency selection for a particular period to a passive benchmark.
chooses among
investments EAFE currency selection would be computed as the weighted average of the currency
denominated in appreciation of the currencies represented in the EAFE portfolio using as weights the
different currencies.
fraction of the EAFE portfolio invested in each currency.
2. Country selection measures the contribution to performance attributable to investing in
country selection
the better-performing stock markets of the world. It can be measured as the weighted
Asset allocation in
average of the equity index returns of each country using as weights the share of the
which the investor
manager™s portfolio in each country. We use index returns to abstract from the effect of
chooses among
investments in security selection within countries. To measure a manager™s contribution relative to a
different countries. passive strategy, we might compare country selection to the weighted average across
Bodie’Kane’Marcus: VI. Active Investment 21. International Investing © The McGraw’Hill
Essentials of Investments, Management Companies, 2003
Fifth Edition

International Investing Raises Questions
• Does international diversification come from the
As Yogi Berra might say, the problem with international
foreign stocks or the foreign currency?
investing is that it™s so darn foreign.
Currency swings? Hedging? International diversifi-
“It comes from both in roughly equal pieces,” Mr.
cation? What™s that?
Riepe says. “Those who choose to hedge their foreign
Here are answers to five questions that I™m often
currency raise the correlation with U.S. stocks, and so
the diversification benefit won™t be nearly as great.”
• Foreign stocks account for some 60% of world stock Indeed, you may want to think twice before investing
market value, so shouldn™t you have 60% of your in a foreign-stock fund that frequently hedges its cur-
stock market money overseas? rency exposure in an effort to mute the impact of”and
make money from”changes in foreign-exchange rates.
The main reason to invest abroad isn™t to replicate
“The studies that we™ve done show that stock
the global market or to boost returns. Instead, “what
managers have hurt themselves more than they™ve
we™re trying to do by adding foreign stocks is to reduce
helped themselves by actively managing currencies,”
volatility,” explains Robert Ludwig, chief investment of-
Mr. Ludwig says.
ficer at money manager SEI Investments.
• Should you divvy up your money among foreign
Foreign stocks don™t move in sync with U.S. shares
countries depending on the size of each national
and, thus, they may provide offsetting gains when the
stock market?
U.S. market is falling. But to get the resulting risk re-
duction, you don™t need anything like 60% of your
At issue is the nagging question of how much to put
money abroad.
in Japan. If you replicated the market weightings of
• So, how much foreign exposure do you need to get Morgan Stanley Capital International™s Europe, Aus-
decent diversification? tralasia and Far East index, you would currently have
around a third of your overseas money in Japan.
“Based on the volatility of foreign markets and the
That™s the sort of weighting you find in international
correlation between markets, we think an optimal port-
funds, which seek to track the performance of the
folio is 70% in the U.S., 20% in developed foreign mar-
EAFE or similar international indexes. Actively man-
kets, and 10% in emerging markets,” Mr. Ludwig says.
aged foreign-stock funds, by contrast, pay less atten-
Even with a third of your stock market money in for-
tion to market weights and on average, these days
eign issues, you may find that the risk-reduction bene-
have just 14% in Japan.
fits aren™t all that reliable. Unfortunately, when U.S.
If your focus is risk reduction rather than perform-
stocks get really pounded, it seems foreign shares also
ance, the index”and the funds that track it”are the
tend to tumble.
clear winners. Japan performs quite unlike the U.S.
• Can U.S. companies with global operations give
market, so it provides good diversification for U.S. in-
you international diversification?
vestors, says Tricia Rothschild, international editor at
Morningstar Mutual Funds, a Chicago newsletter.
“When you look at these multinationals, the factor
“But correlations aren™t static,” she adds. “There™s
that drives their performance is their home market,”
always a problem with taking what happened over the
says Mark Riepe, a vice president with Ibbotson Associ-
past 20 years and projecting it out over the next 20
ates, a Chicago research firm.
How come? U.S. multinationals tend to be owned
by U.S. investors, who will be swayed by the ups and
SOURCE: Jonathan Clements, “International Investing Raises
downs of the U.S. market. In addition, Mr. Riepe notes
Questions on Allocation, Diversification, Hedging,” The Wall Street
that while multinationals may derive substantial profits Journal, July 29, 1997. Excerpted by permission of The Wall Street
and revenue abroad, most of their costs”especially la- Journal. © 1997 Dow Jones & Company, Inc. All Rights Reserved
bor costs”will be incurred in the U.S. Worldwide.

countries of equity index returns using as weights the share of the EAFE portfolio in each
stock selection
Choice of specific
3. Stock selection ability may, as in Chapter 20, be measured as the weighted average of stocks within a
equity returns in excess of the equity index in each country. Here, we would use local country™s equity
currency returns and use as weights the investments in each country. market.

Bodie’Kane’Marcus: VI. Active Investment 21. International Investing © The McGraw’Hill
Essentials of Investments, Management Companies, 2003
Fifth Edition

748 Part SIX Active Investment Management


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