Dynamic International Diversication Strategies

Aleksandar Georgiev Universit de Lausanne, HEC e Sergei Sontchik Universit de Lausanne, HEC and FAME e This draft May 2003

Abstract The main objective of our empirical investigation is to construct and compare the performance of international diversication strategies, optimal with respect to ex-ante maximization of an aggregate performance measure. Our focus is on the real-life portfolio management situation, when portfolio decisions have to be based on expected returns over dierent horizons, facing both uncertainty about the optimality criterion (ultimately determined by a choice of theoretical model) and about the relevant horizon for such a choice. Our work is an empirical investigation of the practical relevance of a particular procedure to strike a balance between these two dimensions of uncertainty in international diversication decisions. PRELIMINARY AND INCOMPLETE!

Introduction

The main objective of our empirical investigation is to construct and compare the performance of international diversication strategies, optimal with respect to ex-ante maximization of an aggregate performance measure. Our focus is on the real-life portfolio management situation, when portfolio decisions have to be based on expected returns over dierent horizons, facing both uncertainty about the optimality criterion (ultimately determined by a choice of theoretical model) and about the relevant horizon for such a choice. Our work is an empirical investigation of the practical relevance of a particular procedure to strike a balance between these two dimensions of uncertainty in international diversication decisions. This paper oers a way to combine several well-known performance measures and use ex-ante maximization of that aggregate performance measure to construct dynamic international diversication strategies. Our motivation to seek such aggregation of performance measures is twofold. First, even though performance measurement dates back at least to the origins of asset pricing theory, there is no general theoretical framework that allows evaluation of the relative eciency of dierent performance measures, as is explained in Chen and Knez (1996). Moreover, there is a multitude of admissible measures, which assign dierent ranking to a given performance. The relative ranking of two allocations, according to one admissible measure can be reversed by another admissible measure. Thus, it is suggested in that paper that a battery of methods to evaluate performance should be used before drawing strong inferences1 . Second, dierent performance measures emphasize dierent aspects of performance and even though the ex-post correlations may be high, there is very little evidence for any tail dependence2 . That is, extremes do not tend to happen together and hence choosing one measure to look at for ex-ante portfolio choice, may not be very prudent thing to do, as chances are rather low that similar portfolio choice can be supported via ex-ante maximization of another measure. In other words, looking beyond ex-post correlations suggests that one should attempt to be optimal among multitude of performance measures and try to smooth out extreme allocations. Our procedure oers a way to do that via endogenous determination of what we call decision
1 2

Chen and Knez (1996), p. 547. See for example Hwang and Salmon (2001).

weights - a measure of how important is a given performance measure for the proposed portfolio choice. The bigger the value a given performance measure takes, relative to the value of the aggregate performance measure, the less its importance in the ultimate determination of the optimal portfolio choice. The intuition behind the procedure is similar to the one used in robust control literature - the decision maker exhibits preferences for robustness across dierent models. There is another link with the literature on robust control we would like to mention. It is discussed in further details in Section 2. In order to determine dynamic international diversication strategies which ex-ante maximize an aggregate performance measure, we construct expected returns over dierent horizons and we do that in a model-independent way. We use the results in Hansen and Jagannathan (1991) to construct Stochastic Discount Factors (SDFs) at dierent horizons via projections on the space of payos for the corresponding horizon. The choice of a time horizon is one long-lasting source of discrepancy between theory and practice. It is obvious that an investment horizon is hardly ever known with certainty at the date when the initial investment decisions are made, and a comprehensive theory of optimal investment under uncertain, and potentially markets driven, time horizon seems to be still lacking3 . In this paper we do not attempt to resolve that theoretical problem, instead we oer an empirical illustration of the importance of the choice of time horizon. We do that in two ways. First, for a static international diversication strategies, we report the evolution of buy-and-hold allocations through time for a range of time horizons. That is we report the allocations, which would ex-ante maximize the aggregate performance measure evaluated with expected returns over a xed rolling horizon. Our second way to illustrate the importance of the choice of time horizon applies for dynamic international diversication strategies. We follow Brandt and Santa-Clara (2002) and use backward induction to generate the portfolio selection matrix up to a predetermined time horizon. Our approach diers from the one in Brandt and Santa-Clara (2002) in two ways. First, we do not use predictive regressions to generate expected returns. Second, our dynamic international diversication strategies are generated via maximization of an objective dierent from the familiar mean-variance one.
See Blanchet-Scalliet, El Karoui, Jeanblanc and Martellini (2002) for an imporatant contribution and review of the relevant literature.
3

It seems important to state that the paper does not attempt to address probably the biggest practical concern - the one about whether and how to rebalance a portfolio. In the context of our paper, the rebalancing decision is about whether to switch or not to a dierent dynamic international diversication strategy. Such a decision would require one to measure how dierent the new strategy is from the remaining part of the old one. Given the complexity of the issue and the fact that we abstract from any frictions, which characterize the real-world markets, the rebalancing problem remains so far beyond the scope of our empirical investigation. The paper is organized as follows, in Section 2 we discuss the algorithm we are using for our empirical investigation, in Section 3 we present our ndings, Section 4 summarizes and concludes.

Methodology

We propose an algorithm to construct dynamic international diversication strategies via ex-ante maximization of an aggregate performance measure. The algorithm requires as input a set of decision parameters, which we believe is relatively easy and intuitive to decide upon and which reect the mood of the decision maker (risk sensitivity and conservatism). Once this set is dened, we proceed in two steps. First, we construct a model-independent proxy for a Stochastic Discount Factor, which we use to generate conditional expected returns over dierent horizons. The outcome of this step is vectors of expected returns at dierent horizons and the implied one-period forward rates up to a prespecied ultimate forecasting horizon. Second, we use dierent performance measures, combined in an exponential aggregator, which we maximize over portfolio decisions and decision weights to produce the main output of our investigation. We report the evolution through time of the international diversication strategies and of the decision weights. We start at a subsample and gradually increasing the number of observations, we recompute the optimum of the exponential aggregator at each point in time. We construct static international diversication strategies using total returns over a xed rolling horizon. In other words, the decision maker adopts buy-and-hold strategy over xed number of periods ahead. At any point in time, that strategy is determined via maximization of the aggregate perfor3

mance measure, using total returns over the same number of periods ahead (rolling horizon). We use the backward induction procedure of Brandt and Santa-Clara (2002), to construct a dynamic international diversication strategy up to the prespecied ultimate forecasting horizon. The procedure consists in rst solving a one period static optimization problem (maximization of the aggregated performance measure) for the last period of the chosen time horizon. Then we move back one period and solve a similar problem using the expected forward returns over that period, compounded by the return on the portfolio decided upon in the previous step.

2.1

Strategy specication

We parameterize the international diversication strategies using the following four parameters. 1. Risk sensitivity parameter () is part of the exponential aggregator and reects decision makers degree of aversion towards uncertainty with respect to the choice of time horizon; Conservatism correction parameter () - it is assumed to take value bigger than one and is used as a multiplier to the estimated maximal pricing error in a downward correction of expected returns, before the objective optimizing portfolio choice is made; Loss tolerance parameter (v) - maximal cumulative loss the decision maker is willing to tolerate, before a change in the investment strategy gets triggered; Ultimate forecasting horizon (H) - the number of periods ahead, beyond which the generated expected returns, become too unreliable.

2.

3.

4.

The decision maker also prespecies two vectors - one of prior decision weights (w), which represent the perceived importance attached to dierent performance measures, and the second one consists of portfolio shares upper bound constraints ().

2.2

Step1 - Expected Returns Determination

We follow Hansen and Jagannathan (1991) and construct the Stochastic Discount Factor at horizon h, as follows:
mt+h = Rt+h = Rt+h at+h = Rt+h Rt+h Rt+h 1

(1)

where Rt+h is the T N matrix of payos at horizon h. In words, we construct Stochastic Discount Factors (SDFs) at dierent horizons via projections on the space of payos for the corresponding horizon. We form h-week in-sample returns and construct the h-horizon SDF, which we use to generate the h-horizon expected returns (out-of-sample). We also generate the implied forward rate for the period between t + h and t + h + 1 as a ratio of the expected return at horizon h + 1 and the one at horizon h. We construct the sample counterpart of the pricing errors vector as follows: T 1 gT (mt+h ) = [yt [rt+h mt+h 1]] (2) T t=1 where yt and rt represent rows of matrices Y and R, and Y is the T M matrix of instruments. The expected return on asset i for horizon h is constructed as follows:
i Rt+h = Et Rt+h = i covt (Rt+h , mt+h ) 1 + Et (mt+h ) Et (mt+h )

(3)

Then the vector of expected returns gets corrected downwards with the -multiple of vector of pricing errors gT (mt+h ), dened in (2). The variancecovariance matrix of gT (mt+h ), is prodiced via a GMM estimation with Newey-West HAC estimator. The purpose of this correction is to lower the possibility of acting upon too optimistic forecasts in the next step of our algorithm. We also adjust the variance-covariance matrix of expected returns - we add the estimated variance covariance matrix of the pricing errors, multiplied by 2 , to the estimator of the N N variance-covariance matrix of expected returns, obtained as described in the Section 2.2.1. This correction is based on the assumption that the pricing errors are independent from expected returns, which is partly justied by the construction procedure itself.

2.2.1

Covariance matrix estimator

Shrinkage estimator of variance-covariance matrix is proposed in Ledoit and Wolf (2000) and consist in nding an optimal combination between a sample estimator and a prior estimator, where the optimality is in the sense of weighting bias against eciency. The sample covariance matrix estimator is: SN,h 1 = T 1
T

rh rh t
t=1

rh rh t

(4)

h where T is the sample size, rt is a N 1 vector of stock returns in period t at horizon h, and rh is the average of these return vectors. The prior estimator could be Sharpes (1964) single-factor model, or any other factor model. We follow Jagannathan and Ma (2000) and assume that h h rit = i + i rmt + it

(5)

h Here rmt is the market return proxy for period t (the world market index) at horizon h. For that factor model the covariance estimator is

S1,h = bs2 b + D m,h

(6)

h Here b is the vector of i s, s2 is the sample variance of rmt , and D m,h contains the sample variances of the residuals. We use GMM to estimate (5) and to construct S1,h we use the corresponding estimates. The optimal shrinkage estimator of Ledoit and Wolf (2000) is a weighted average of the sample covariance matrix estimator in (4) and the one factor model estimator in (6). Specically,

SL,h =

S1,h + 1 SN,h T T

(7)

where is a parameter that determines the shrinkage intensity and is consistently estimated from the data. Re-estimation at every point in time using the estimator in (7) can be viewed as the middle ground between assuming constant variance covariance matrix, on the one hand, and assuming multivariate GARCH-like evolution of the conditional variance covariance matrix, on the other. As is demonstrated in Ledoit and Wolf (2000) this estimator performs very well when the number 6

of assets increases relative to the number of observations. In the context of the present paper, the longer the ultimate forecasting horizon H, the more relevant the estimator in (7) becomes. In other words, the estimator in (7) allows us to meet two very important problems in applications - time varying correlations and relatively large number of assets. Jagannathan and Ma (2000) propose to incorporate no-short sales constraints and upper bounds on portfolio shares constraints in the variancecovariance matrix estimator and treat the minimum variance portfolio as unconstrained problem. We use the same procedure as follows: SL,h = SL,h [i + j (i + j )]N i,j=1 (8) where is a vector of Lagrange multipliers from the portfolio shares upper bound constraints and is a vector of Lagrange multipliers from the portfolio shares non-negativity constraints. Thus (8) performs an element by element correction of the covariance matrix estimator, which shrinks both small covariances (which lead to huge portfolio shares) and large covariances (which lead to short positions) towards average covariances. We compute the multiplies in and numerically, using a built-in procedure in Optimization toolbox of Matlab 5.3. That is where the set of upper bound constraints on portfolio shares, dened in Section 2.1, is used. In all subsequent computations we use the covariance matrix estimator, constructed according to (8). That estimator allows us to incorporate portfolio constraints and at the same time to preserve the unconstrained formulation of the optimization objective, with the only exception being the path dependent constraint implied by the loss tolerance parameter v, dened in Section 2.1.

2.3

Step 2 - Optimal Strategy Determination

The Optimal dynamic international diversication strategy is dened as follows: = arg max w (p ()) PN for j = 1 to H (9)

s.t.

j fh,1 > 1 v h=1

(10)

where fh,1 represents the vector (a column of the N H matrix F) of the implied forward expected returns between periods t + h and t + h + 1. 7

Thus the sequence of constraints in (10) represents the idea that the decision maker would like ex-ante to avoid hitting certain loss level, represented by the loss tolerance parameter v. The N 1 vector of constrained portfolio shares4 belongs to
N

PN =

x = (x1 , ..., xK ) xk 0 for all k, and

k=1

xk = 1

The function w (p ()) is exponential aggregator dened as follows: 1 w (p ()) = log

K

wk exp (pk ())

k=1

where we will use < 0 and p () is a K 1 vector of objectives, with each element corresponding to a performance measure, evaluated at a vector of portfolio shares , common for all measures. Since all of the K objectives are considered relevant, all elements of vector w of xed predetermined weights satisfy wk > 0. The necessary N conditions for maximum can be represented as
K

k
k=1

p () = 0 j for j = 1, ...N

(11)

where k k () = or k () = wk exp ( (pk () w (p ()))) () PK (13) w (p ()) = fk wk exp (pk ())

K l=1

wl exp (pl ())

(12)

We would like to emphasize a link with robust control literature, which will provide an interpretation of the parameter . That parameter is called
As explained in Section 2.2.1, the portfolio constraints in (9) get incorporated in the variance-covariance matrix estimator. We state them explicitly mostly for completeness of the exposition.
4

degree of fuzziness in Richardt et al. (1996), but it can also be interpreted as risk sensitivity parameter, as in Hansen and Sargent (2001). To see this note that equations (37) and (38) in Richardt et al. (1996) state respectively:
K xPK

max B (x, p) =
k=1

xk pk ()

1 H (x)

for > 0 and w = 1K where H (x) is Shannon entropy and where at the optimum x = () , which gives B ( () , p ()) = w=1 (p ()) When the vector of initial weights w = 1K , then one has to replace the Shannon entropy term H ( ()) with the so called directed divergence :
K

div ( () , w) =
k=1

k () log

k () wk

H ( ()) = div ( () , 1) Note also that from (13) we can interpret () as vector of decision weights, which represent how the initial importance wk of given criterion pk gets augmented due to the need to compromise. Thus a higher decision weight can be interpreted as the corresponding criterion being more relevant for the optimal portfolio choice. In other words, k () close to one means that the optimal portfolio is chosen almost entirely to maximize performance measure pk as can be seen from (11). 2.3.1 Performance measures

In this section we briey describe the performance measures we use. We scale each measure by the value the corresponding measure takes, when evaluated at the benchmark portfolio5 . Such scaling is necessary for two reasons, one is that it makes the performance measure admissible in the sense of Chen and Knez (1996) and the other is that the value of the aggregator, and hence the decision weights, may be adversely aected if there is a large discrepancy among the numerical values dierent objectives may take.
Jensens alpha and the Information ratio remain unscaled as they are already admissible performance measures.
5

Information ratio and Treynor measure Treynor measure is well-known and hence we need to only restate it in terms of the notation used in the paper: p1 () = Rt+h Rf as: . b The corresponding derivatives with respect to are two 1 N vectors with respective elements as: p1 () = Rj,t+h j
1

where Rt+h is dened in (3) and is an N 1 vector with its j-th element j = Cov Rj,t+h , Rb

1 Rt+h Rf j 2

We include information ratio (instead of Sharpe ratio) as performance measure because it seems to be rather popular in practise and because it denes an admissible performance measure in the sense of Chen and Knez (1996). For this and other measures we need a benchmark return Rb , which in most of the analysis we choose to be the world index return. We aim at constructing a portfolio, which is expected to outperform the benchmark. Information ratio is dened as follows: p2 () = Rt+h Rb Se L,h
1/2

where Se denotes the variance-covariance matrix of excess returns6 . The L,h corresponding 1 N row vector of derivative with elements: p2 () = Rj,t+h Se L,h j
6

1/2

Rt+h Rf

Se L,h

1/2

Se,j L,h

Depending on the purpose of the empirical investigation one may resort to dierent benchmarks. For example, one can consider the home bias puzzle. A given country portfolio manager, evaluated on the basis of its performance relative to its home country market index, will determine its international diversication strategy based on the ability of such a strategy to outperform its home benchmark. As some country indecies may be harder to outperform, one may expect home bias to be less of a puzzle for these countries.

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Jensens alpha The performance measure is dened as follows: p3 () = Rt+h Rf Rt+h Rf . and the derivative with respect to is a 1 N row vector, with elements like: p3 () = 1 Rj,t+h Rt+h Rf j j Net selectivity (Famas measure) The measure of net selectivity, proposed by Fama (1972), is dened as follows: p4 () = Rt+h Rf (Rb Rf )
Selectivity

1 SL,h b

1/2

(Rb Rf )

Diversication

and the derivative with respect to is a 1 N row vector, with elements like: 1/2 p4 () Rb Rf = Rj,t+h + SL,h Sj L,h j b where Sj denotes the j-th column of the variance-covariance matrix L,h estimator from (8). Using the above derivatives we can rewrite the system of equations in (11) as follows: J () () = 0 (14) The following is a representation of the j-th column of the K N matrix J () above:

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 Rj,t+h Se L,h

1 1/2

Rt+h Rf +

j Se L,h
1/2

Se,j L,h Sj L,h

1 1

j
1 b SL,h 1/2

0 0
b Rb Rt+h b

SL,h 0

1/2

Sj L,h

We solve the sytem in (14) numerically using Matlab Optimization toolbox routine called fsolve.

Anticipated Results

The data set is collected from Datastream and ranges from December 1983 to July 2002. Our data are weekly returns on country capital market indices for the G-7 countries plus Switzerland. It gives us 970 observations for each time series of interest. In addition to the eight country stock market indices we have a weekly world index which is used as a benchmark for performance measures. All the indices are dollar denominated. In addition to the stock market indices we use one-month Eurodollar rates. Table 1 provides summary statistics for the payos of the assets of interest. For a static international diversication strategies, we will report the evolution of buy-and-hold allocations through time for a range of time horizons. That is we will report the allocations, which would ex-ante maximize the aggregate performance measure evaluated with expected returns over a xed rolling horizon. We will also report the evolution of the portfolio weights of a dynamic strategy, constructed as follows - rst we x the length of the strategy (that is for how many periods ahead we produce expected returns), then we use backward induction to determine the portfolio weights for each period and we will report their optimal evolution as the last period approaches (horizon 12

shrinks). We will report the impact of a choice of length of the strategy on the initial portfolio weights (those to be implemented at the time the optimization is made). Table 1. Descriptive statistics of payos: means and standard deviations World index Swiss index US index German index UK index French index Japanese index Canadian index Italian index Swiss int. rate US int. rate German int. rate UK int. rate French int. rate Japanese int. rate Canadian int. rate Italian int. rate Mean Standard Deviation 1.0988 0.1425 1.1224 0.1579 1.1125 0.1639 1.0944 0.1849 1.1029 0.1536 1.1309 0.1876 1.0466 0.1973 1.0859 0.1463 1.1309 0.2339 1.0398 0.0041 1.0606 0.0029 1.0522 0.0028 1.0847 0.0044 1.0699 0.0042 1.0322 0.0037 1.0704 0.0041 1.0942 0.0055

Our expectations concerning the results at this stage of development are the following: 1. The aggregated performance measurement procedure should lead to a rather smooth portfolio allocation across horizons. Apart from the lowvolatility nature of expected returns we expect the smoothness of portfolio allocation should come from a maximization of several performance measures simultaneously; 2. We expect that across time, for a xed horizon, each measure maximization should produce optimal portfolios, which signicantly vary with time, and hence may lead to potentially signicant transaction costs. In any case such a concern is much less of an issue, when compared to existing results in the literature7 ;
7

See for example Baras and Isakov (2001) and the references therein.

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3. We are interested to see the time evolution of decision weights (is it stable or not). The evolution of decision weights across horizons reects the evolution of the importance of one or the other measure.

Summary and Extensions

Some preliminary conclusions: 1. The smoothing parameter plays crucial role and thorough comparative statics analysis is required; 2. Rebalancing issues need to be addressed, but so far seem not to be an issue; This paper represents a research in progress and we would like to pursue research in several directions. 1. Enlarge the set of assets priced. This is a non-trivial extension direction as pricing non-linear asset payos puts the pricing abilities of our model-free procedure to a test; 2. Investigate the impact of other path dependent constraints, such as Conditional Value at Risk (CVaR);

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