4.1.3 International diversification
Portfolio theory offers the investor the ability to create efficient portfolios from a selection of investment alternatives, ranging from choosing a portfolio of UK equities or a set of overseas markets in which to invest, to making an asset allocation choice between UK equities, overseas equities, cash and bonds, for example. In each case, a set of efficient portfolios can be created, provided that the investor has a database of the expected returns, risks and correlation coefficients.
In practice, investors tend to use historical data to estimate the risks and correlations, in particular. Expected returns chosen are more likely to be subjective estimates. The risks and measures of correlation might be calculated from, for example, the past 12 monthly periods, the past 20 quarters, or the past 10 annual periods.
The financial publication Money Management, for example, publishes the standard deviation from the most recent 36 monthly periods. Each choice of data will give a different answer and, to make matters worse, the efficient frontier portfolios that the analysis provides may be difficult to sell to investors in practice.
Suppose that an international equity market analysis suggested that US investors should place 50% in Belgian equities, 5% in the UK and the remainder in Chile. This might appear too different from a market-capitalisation-weighted global equity index to please investors. So analysts tend to play it safe and constrain their models to give answers that are not likely to change too much, and that are not that different from a popular benchmark index.
The Capital Asset Pricing Model (CAPM) is also based on assumptions that do not hold in practice. Investors based in different currencies will not all be looking at the same opportunities; investors cannot in practice both borrow and lend at the risk-free rate; and the market indices used to represent the market are not very good approximations to estimates of all marketable assets.
However, the conclusions that the CAPM reaches – that there is, for passive investors, an investment alternative based on index funds and cash, that active managers can be judged relative to that passive investment alternative, and that investors can analyse what kinds of risk investment funds are taking on – have meant that investment managers have to be very careful to implement the investment strategies that they put in their marketing literature.
These observations bring us to the next key aspect of investment management: how to judge investment performance – including the performance of fund managers who look after your investment portfolios.