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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 Cam.harvey@duke.edu +1 919.660.7768 office || +1 919.271.8156 mobile

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slide1

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

slide2

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
slide3

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)

slide13

Returns and Diversification

Data from IFC and MSCI

slide14

The Long Horizon

Data from Dimson, Marsh and Stauton (2002)

slide15

The Long Horizon

Data from Dimson, Marsh and Stauton (2002)

slide16

The Long Horizon

Data from Dimson, Marsh and Stauton (2002)

slide17

The Long Horizon

Data from Dimson, Marsh and Stauton (2002)

slide18

What to Expect

Data from Dimson, Marsh and Stauton (2002)

slide19

What to Expect

Source: Goldman Sachs (2002)

slide20

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)

slide21

What to Expect

U.S. Equity and Bond Returns are Positively Correlated

Source: Erb and Harvey (2004)

slide22

What to Expect

World Real Equity and Real Bond Returns are Positively Correlated

Source: Erb and Harvey (2004)

slide23

What to Expect

Inflation Negatively Related to Real Bill Returns

Source: Erb and Harvey (2004)

slide24

What to Expect

Inflation Negatively Related to Real Intermediate Bond Returns

Source: Erb and Harvey (2004)

slide25

What to Expect

Inflation Negatively Related to Real Bond Returns

Source: Erb and Harvey (2004)

slide26

What to Expect

Inflation Negatively Related to Real Equity Returns

Source: Erb and Harvey (2004)

slide27

What to Expect

Inflation Negatively Related to Real International Bill Returns

Source: Erb and Harvey (2004)

slide28

What to Expect

Inflation Negatively Related to Real International Bill Returns

Source: Erb and Harvey (2004)

slide29

What to Expect

Inflation Negatively Related to Real International Equity Returns

Source: Erb and Harvey (2004)

slide30

What to Expect

Inflation Negatively Related to Real International Equity Returns

Source: Erb and Harvey (2004)

slide31

Alternative Vehicles

Alternate Asset Classes Often Involve Implicit or Explicit Options

Source: Naik (2002)

slide32

Alternative Vehicles

Alternate Asset Classes Often Involve Implicit or Explicit Options

Source: Naik (2002)

slide33

Alternative Vehicles

Alternate Asset Classes Often Involve Implicit or Explicit Options

Source: Naik (2002)

slide34

Alternative Vehicles

Alternate Asset Classes Often Involve Implicit or Explicit Options

Source: Naik (2002)

slide35

Alternative Vehicles

Alternate Asset Classes Often Involve Implicit or Explicit Options

Source: Figure 5 from Mitchell & Pulvino (2000)

slide36

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

slide37

Rethinking Risk

  • Traditional models maximize expected returns for some level of volatility
  • Is volatility a complete measure of risk?
slide38

Rethinking Risk

  • Much interest in downside risk, asymmetric volatility, semi-variance, extreme value analysis, regime-switching, jump processes, ...
slide39

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:
slide40

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
slide41

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
slide42

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!]
slide43

Rethinking Risk

Source: Harvey and Siddique (2000)

slide44

Rethinking Risk

Data from MSCI

slide45

Rethinking Risk

Data from IFC

slide46

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
slide47

U.S. Has Become a Riskier Global Investment

ICRG

Political Risk

Data from PRS

slide48

U.S. Has Become a Riskier Global Investment

ICRG

Political Risk

Data from PRS

slide49

U.S. Has Become a Riskier Global Investment

ICRG

Political Risk

Data from PRS

slide50

U.S. Has Become a Riskier Global Investment

Risk Ratings December 2002

Data from PRS

slide51

U.S. Has Become a Riskier Global Investment

Risk Ratings May 2001

Data from PRS

slide52

U.S. Has Become a Riskier Global Investment

Higher risk means equity investors require a higher rate of return

Risk Ratings from Institutional Investor

u s has become a riskier global investment
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)
conclusions
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
readings
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