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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 [email protected] +1 919.660.7768 office || +1 919.271.8156 mobile

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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

[email protected]

+1 919.660.7768 office || +1 919.271.8156 mobile

http://www.duke.edu/~charvey


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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


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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

Wilshire Small Cap

Seven Year Treasury STRIP

Credit

MBS

Five Year Treasury STRIP

Aggregate

Government

EAFE

Three Year Treasury STRIP

Two Year STRIP

One Year Treasury STRIP

Source: Erb and Harvey (2004)











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Returns and Diversification

Data from IFC and MSCI


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The Long Horizon

Data from Dimson, Marsh and Stauton (2002)


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The Long Horizon

Data from Dimson, Marsh and Stauton (2002)


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The Long Horizon

Data from Dimson, Marsh and Stauton (2002)


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The Long Horizon

Data from Dimson, Marsh and Stauton (2002)


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What to Expect

Data from Dimson, Marsh and Stauton (2002)


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What to Expect

Source: Goldman Sachs (2002)


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What to Expect

  • Ten-year risk premium around 3.5% and stable whereas one-year risk premium quite variable

10-year premium

1-year premium

Source: Graham and Harvey (2005)


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What to Expect

U.S. Equity and Bond Returns are Positively Correlated

Source: Erb and Harvey (2004)


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What to Expect

World Real Equity and Real Bond Returns are Positively Correlated

Source: Erb and Harvey (2004)


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What to Expect

Inflation Negatively Related to Real Bill Returns

Source: Erb and Harvey (2004)


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What to Expect

Inflation Negatively Related to Real Intermediate Bond Returns

Source: Erb and Harvey (2004)


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What to Expect

Inflation Negatively Related to Real Bond Returns

Source: Erb and Harvey (2004)


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What to Expect

Inflation Negatively Related to Real Equity Returns

Source: Erb and Harvey (2004)


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What to Expect

Inflation Negatively Related to Real International Bill Returns

Source: Erb and Harvey (2004)


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What to Expect

Inflation Negatively Related to Real International Bill Returns

Source: Erb and Harvey (2004)


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What to Expect

Inflation Negatively Related to Real International Equity Returns

Source: Erb and Harvey (2004)


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What to Expect

Inflation Negatively Related to Real International Equity Returns

Source: Erb and Harvey (2004)


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Alternative Vehicles

Alternate Asset Classes Often Involve Implicit or Explicit Options

Source: Naik (2002)


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Alternative Vehicles

Alternate Asset Classes Often Involve Implicit or Explicit Options

Source: Naik (2002)


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Alternative Vehicles

Alternate Asset Classes Often Involve Implicit or Explicit Options

Source: Naik (2002)


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Alternative Vehicles

Alternate Asset Classes Often Involve Implicit or Explicit Options

Source: Naik (2002)


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Alternative Vehicles

Alternate Asset Classes Often Involve Implicit or Explicit Options

Source: Figure 5 from Mitchell & Pulvino (2000)


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Alternative Vehicles

Alternate Asset Classes Often Involve Implicit or Explicit Options

6

4

2

0

-15

-10

-5

0

5

10

Event Driven Index Returns

-2

-4

LOWESS fit

-6

-8

Source: Naik (2002)

Russell 3000 Index Returns


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Rethinking Risk

  • Traditional models maximize expected returns for some level of volatility

  • Is volatility a complete measure of risk?


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Rethinking Risk

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


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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:


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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


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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


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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!]


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Rethinking Risk

Source: Harvey and Siddique (2000)


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Rethinking Risk

Data from MSCI


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Rethinking Risk

Data from IFC


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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


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U.S. Has Become a Riskier Global Investment

ICRG

Political Risk

Data from PRS


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U.S. Has Become a Riskier Global Investment

ICRG

Political Risk

Data from PRS


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U.S. Has Become a Riskier Global Investment

ICRG

Political Risk

Data from PRS


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U.S. Has Become a Riskier Global Investment

Risk Ratings December 2002

Data from PRS


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U.S. Has Become a Riskier Global Investment

Risk Ratings May 2001

Data from PRS


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U.S. Has Become a Riskier Global Investment

Higher risk means equity investors require a higher rate of return

Risk Ratings from Institutional Investor


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U.S. Has Become a Riskier Global Investment

  • Equation implies an increase in the medium-term risk premium of 240bp

    • 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)


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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


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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


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