Diversification and the benefits of using returns standardized by range‐based volatility estimators

• Published date: 01 April 2019
• Author: José Luis Miralles‐Quirós,María Mar Miralles‐Quirós,José Manuel Nogueira
• Date: 01 April 2019
• DOI: http://doi.org/10.1002/ijfe.1685

RESEARCH ARTICLE

Diversification and the benefits of using returns

standardized by range‐based volatility estimators

José Luis Miralles‐Quirós

1

| María Mar Miralles‐Quirós

1

| José Manuel Nogueira

2

1

Department of Financial Economics,

University of Extremadura, Badajoz, Spain

2

Polytechnic Institute of Tomar, Tomar,

Portugal

Correspondence

José Luis Miralles‐Quirós, Department of

Financial Economics, University of

Extremadura, Av. Elvas s/n 06006,

Badajoz, Spain.

Email: miralles@unex.es

Funding information

Junta de Extremadura, Grant/Award

Number: V Action Plan for Research and

Development 2014/17

JEL Classification: G10; G11; G14

Abstract

The aim of our research is to analyse the benefits for the U.S. investors of

combining their domestic exchange trade fund (ETF) with ETFs, which track

other developed markets such as the United Kingdom, Japan, Germany, and

France. We evaluate the out‐of‐sample performance of six strategies using the

returns and volatility forecasts from a VAR Asymmetric Dynamic Conditional

Correlation GARCH approach where returns standardized by range‐based

volatility estimators were used as endogenous variables. The initial

outperformances of some strategies using classic returns were significantly

improved when returns were standardized by the Garman–Klass precise

volatility estimator. Additionally, we find a large decrease in the weights of

the North American ETF in the best performing strategies, meaning that it is

possible to obtain benefits from diversification. These findings are relevant

not only for academics but also for active professional managers who can use

this technique to add value to their international diversification strategies.

KEYWORDS

developed markets, exchange trade funds, international diversification, out‐of‐sample performance,

range‐volatility estimators, standardized returns

1|INTRODUCTION

Over the last decade, numerous studies have provided evi-

dence of the attractiveness of emerging markets due to their

lower correlation with the United States (Christoffersen,

Errunza, Jacobs, & Jin, 2014; Christoffersen, Errunza,

Jacobs, & Langlois, 2012; Lehkonen & Heimonen, 2014;

Yarovaya & Lau, 2016; Yuan, Gupta, & Roca, 2016). In con-

trast, international diversification in developed markets has

become less attractive for the U.S. investors as the correlation

between markets has steadily risen. In this context, the U.S.

investors in particular display a preference for home‐based

investments. This phenomenon is known as the home bias

puzzle, and its possible explanations are foreign investment

restrictions, capital controls, transaction costs, and asymmet-

ric information (O'Hagan‐Luff & Berrill, 2015).

Despite these circumstances, there is an indirect

method of achieving the benefits of international diversi-

fication, namely, investing in securities that trade domes-

tically and provide international exposure while avoiding

the costs and risks of investing abroad. Nowadays, there

are several indirect routes through which an investor

may achieve exposure to foreign equity returns in a

domestic setting, such as the Exchange Trade Funds

(ETFs). These assets are very similar to open‐ended

funds, but they can be transacted at market price any

time during the trading day.

The vast majority of researchers have employed mul-

tivariate GARCH and MGARCH specifications to param-

eterize the dynamic equation for the conditional

covariance and estimate multistep ahead forecasts to con-

struct their optimal portfolios. However, the Gaussian

Received: 17 January 2018 Revised: 20 July 2018 Accepted: 10 September 2018

DOI: 10.1002/ijfe.1685

Int J Fin Econ. 2019;24:671–684. © 2018 John Wiley & Sons, Ltd.wileyonlinelibrary.com/journal/ijfe 671