The international diversification benefits of U.S.‐traded equity products

• DOI: http://doi.org/10.1002/ijfe.1714
• Date: 01 July 2019
• Author: Jenny Berrill,Martha O'Hagan‐Luff
• Published date: 01 July 2019

RESEARCH ARTICLE

The international diversification benefits of U.S.‐traded

equity products

Martha O'Hagan‐Luff | Jenny Berrill

School of Business, Trinity College

Dublin, Dublin, Ireland

Correspondence

Jenny Berrill, School of Business, Trinity

College Dublin, Dublin, Ireland.

Email: jberril@tcd.ie

Funding information

Irish Research Council

JEL Classification: F30; G11; G15

Abstract

The benefits of international diversification for equity investors have been

highlighted for decades. Despite the reduction of many previous barriers to for-

eign investment, investors are found to persistently overweight domestic equi-

ties. This paper examines whether the benefits of international diversification

are available via U.S.‐traded equity products over a 15‐year period between

1996 and 2011. The equity products investigated are multinational corporations

(MNCs), American depository receipts (ADRs), single‐country exchange‐traded

funds, iShares, and closed‐end country funds. Mean‐variance spanning tests

and Sharpe ratio analysis reveal that portfolios of ADRs and MNCs offer the

greatest international diversification benefits to U.S. investors in a domestic

setting. Whereas the benefits of international diversification vary during

periods of differing market conditions, the findings for ADRs and MNCs

remain robust. We conclude that it is possible to reap the benefits of interna-

tional diversification via U.S.‐traded equity products but that the benefits of

different equity types vary significantly.

KEYWORDS

American depository receipts, exchange‐traded funds, international diversification, mean‐variance

spanning, US multinational corporations

1|INTRODUCTION

The benefits of international portfolio diversification have

been extensively highlighted (Driessen & Laeven, 2007;

Levy & Sarnat, 1970; Solnik, 1974), as low correlations

among national stock markets allow investors to reduce

their risk for a given return. Despite these benefits and

despite the reduction of many barriers to international

investment, investors hold a disproportionate amount of

their investments domestically, known as the home bias

puzzle (Abid, Leung, Mroua, & Wong, 2014; Abid,

Mroua, & Wong, 2013; Ahearne, Griever, & Warnock,

2004; French & Poterba, 1991; VanNieuwerburgh &

Veldkamp, 2009). Although investing domestically may

appear to be a suboptimal investment strategy, recent

studies find that many of the benefits of international

diversification can be achieved indirectly by investing in

multinational corporations (MNCs; Cai & Warnock,

2012; Farooqi, Huerta, & Ngo, 2015; O'Hagan‐Luff &

Berrill, 2015).

Although a large literature exists investigating the

indirect diversification benefits of investing in MNCs

(Cai & Warnock, 2012; Errunza, Hogan, & Hung, 1999;

O'Hagan‐Luff & Berrill, 2015), less attention has been

given to other products that trade domestically and may

provide international exposure, such as American depos-

itory receipts (ADRs), iShares, and closed‐end country

funds (CCFs). Existing studies examine the international

diversification benefits of one type of equity product,

whereas some studies compare two (Coe, 2002; Harper,

Received: 22 November 2017 Revised: 13 July 2018 Accepted: 9 September 2018

DOI: 10.1002/ijfe.1714

1238 © 2018 John Wiley & Sons, Ltd. Int J Fin Econ. 2019;24:1238–1253.wileyonlinelibrary.com/journal/ijfe

Madura, & Schnusenberg, 2006; Pennathur, Delcoure, &

Anderson, 2002). We take the analysis a step further

and compare the benefits of investing in a number of

equity products that trade in the United States and

provide exposure to foreign markets in a domestic

setting: MNCs, ADRs, and two types of country‐specific

exchange‐traded funds (ETFs), iShares and CCFs. We

are unaware of any previous study that directly compares

the benefits of investing in all of these equity products.

Using mean‐variance spanning (MVS) and Sharpe

ratio tests, we compare the diversification benefits of

investing in portfolios of these products from 1996 to

2011. We compare the results with the hypothetical ben-

efits of investing in 37 foreign country indices over the

same period. We test the diversification benefits under

three scenarios, optimizing portfolio weights with and

without short sales and using the more restrictive

scenario of equally weighted portfolios. Given the time‐

varying nature of diversification benefits, we perform

our analysis over subperiods to test our results under

alternative market conditions. We hypothesize that the

conflicting results on the indirect benefits of investing in

MNCs in existing literature may be in part attributable

to the use of measures of the extent rather than the scope

of internationalization in compiling MNC samples. We

therefore create a unique sample of the most interna-

tional firms using a system first proposed by Aggarwal,

Berrill, Hutson, and Kearney (2011) that focuses on the

location rather than the level of firms' foreign sales. We

believe that this provides a more robust method to

compile our MNC sample.

We find that when portfolios are equally weighted,

significant diversification benefits via investment in

either foreign country indices or U.S.‐traded products

are available only during the period 2003 to 2007. The

periods preceding and following this both contained crisis

events, the crash of the dotcom bubble and the credit

crisis, and as found by Longin and Solnik (1995), interna-

tional diversification benefits are greatly reduced during

crisis periods as international correlations tend to

increase. When portfolio weights are optimized, diversifi-

cation benefits exist in all subperiods, with portfolios of

ADRs and MNCs yielding the greatest benefits. We find

that ETFs, iShares and CCFs, offer consistent diversifica-

tion benefits only when short sales are allowed and that,

in most cases, these benefits are less than those of ADRs

and MNCs. The firms represented by ADRs in our

sample are in most cases highly internationalized, leading

us to conclude that highly internationalized firms,

whether domestic or foreign, provide the greatest

diversification benefits to investors. We find that it is pos-

sible to reap the benefits of international diversification

via U.S.‐traded equity products but that the benefits vary

significantly by equity product and that the relative

benefits differ in varying market conditions.

The remainder of the paper is structured as follows.

Section 2 reviews previous research into the international

diversification benefits of U.S. equity products. Section 3

describes our data and methods. In Section 4, we discuss

our results, and in Section 5, we summarize our findings

and conclude our analysis.

2|DISCUSSION OF THE

LITERATURE

Early studies recommend international diversification of

investment portfolios (Levy & Sarnat, 1970; Solnik,

1974). More recently, Driessen and Laeven (2007) find

that these benefits continue to exist but are decreasing

over time. However, the long‐term benefits of interna-

tional diversification have been defended by You and

Daigler (2010), Asness, Israelov, and Liew (2011), and

Christoffersen, Errunza, Jacobs, and Langlois (2012).

Despite the benefits of international diversification and

the reduction of many previous barriers to international

investment, home bias in portfolio investment continues

to exist (Morse & Shive, 2011). The phenomenon of home

bias was first documented by French and Poterba (1991),

and subsequently by Tesar and Werner (1995), Ahearne

et al. (2004), and VanNieuwerburgh and Veldkamp

(2009). Its existence is considered to be one of the least

contentious empirical findings in international finance.

Traditional explanations include exchange rate and coun-

try risk, costs and restrictions of investing abroad, and

informational asymmetry. However, Cai and Warnock

(2012) suggest that home bias is greatly overstated due

to the fact that the international exposure of U.S. MNCs

is not counted as foreign equity holdings. Investors' ten-

dencies to overinvest domestically may be partly due to

a preference for this indirect foreign exposure. Errunza

et al. (1999) find that U.S. investors can replicate the

returns of 11 out of 16 foreign markets by investing in

MNCs, CCFs, and ADRs between 1976 and 1993. They

claim that the gains from international diversification

are overstated and should only be measured beyond those

attainable through home‐based diversification.

1

The results of previous studies investigating the inter-

national diversification benefits of investing in MNCs

have been mixed. Studies by Jacquillat and Solnik

(1978), Brewer (1981), Michel and Shaked (1986), and

Salehizadeh (2003) find that U.S. MNCs do not mimic

1

We extend Errunza, Hogan and Hung (1999) by adding single‐country

iShare ETFs to the analysis and comparing portfolios of equity products

rather than using a stepwise approach of augmenting diversification

portfolios.

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