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Asian Review of Financial Research Vol.24 No.4 pp.1113-1151
The Effectiveness of International Small-Cap Stocks on Portfolio Diversification
Seong-Hoon Lee* Professor, School of Economics and Business, Cheongju University
Jong-Mun Yoon Researcher, Korea Capital Market Institute Ph.D. Candidate, Department of Economics, Seoul National University
Key Words : Spanning Test,International Diversification,Small-Cap,International Fund,Market Globalization,Spanning Test


This paper analyzes how international small-cap stocks affect portfolio diversification from the perspectives of Korean investors who hold stakes in the major 24 countries' MSCI small-cap index funds. We also examine correlations between cap-based index funds for the whole period from June 1994 to December 2010 and its sub-periods. Finally, we perform the Huberman-Kandel mean-variance spanning tests on the returns of the small-cap funds from those countries, in the cases of both fully-hedged and no-hedged risks for foreign exchange rate volatility. Korean investors' investments in international funds have sharply grown thanks to the backdrop of Korea's quickly expanding fund industry. In fact, Korea's total fund sales have grown from KRW 234 trillion as of the end of 2006 to KRW 309 trillion at the end of 2010, recording a compound annual growth rate of 8%. The figure of Korea's total fund sales as of the end of 2010 is equivalent to 30% of Korea's GDP or 27% of Korea's stock market capitalization. Especially, the proportion of Korea's international fund investments among total fund sales has grown from 8% at the end of 2006 to 21% at the end of 2010. Generally, investment in international funds is an effective way to diversify a portfolio, thereby reducing risks inherent to asset investments. Accordingly, one may expect that portfolio diversification through international fund investments is to be more active as a coping mechanism during a financial crisis. Interestingly, however, during the previous global financial meltdown Korea's international fund investments lagged behind domestic fund investments. In fact, as of the end of 2010, while Korea's total fund sales went up by 10%, Korea's total international fund sales dropped by 13% compared to 2007. This shows Korean investors' shifted risk-minimizing strategy by reducing, rather than boosting, international fund investments . This change in the strategy can be explained by the fact that global crisis generates the effect of diluting the advantage of international portfolio diversification, shrinking the benefits from diversified international investments became smaller as a result. In short, Korean investors make the endogenous portfolio choices mainly to reduce international fund investments while increasing domestic fund investments that are less affected by the global crisis. This article, therefore, studies whether Korean investors can utilize the benefits of international diversification with small-cap funds. For this study, we used Datastream's MSCI monthly indices covering small- and large-cap funds from 24 countries during the period from June 1994 to December 2010 and its sub-periods (the period from June 1994 to December 2002 and the period from January 2003 to December 2010). We analyze: returns, risks, and the Sharpe index of each cap-based fund by country; the correlation of each cap-based fund; the mean-variance spanning tests for small-cap funds; and their relation with international exchange rates. The main results can be summarized as follows. First, cap-based returns of both smalland large-cap funds in Korea were negatively correlated with changes in the international exchange rates in major economies around the world. Taking into account the positive correlation between international and domestic fund returns, we found that international exchange rates have a complementary relationship with international fund returns because the reduction in international fund returns would be smaller than the favorable changes in exchange rates in case of global crisis. Thus, risks incurred by international fund investments would be less when international exchange risks are not hedged. Second, global integration has eroded the benefits of diversifying investments across different countries, industries, and cap-based stocks. Especially global integration and, hence, the weakening benefits of international portfolio diversification have been accelerated since the year 2000. Third, Korea showed less correlation with BRICs countries than it did with developed countries or Asia, and the Sharpe ratios of BRICs countries were higher than those of other countries. While Korean investors' international fund diversification to BRICs countries was more effective than it was to other countries, the Korean economy was, nevertheless, highly correlated with Asian countries. Also, the Sharpe ratios of Asia countries were higher than those of other countries. The benefits from international portfolio diversification in Asian countries were likely to be smaller, which can prompt the decrease in Korean investors' international fund investments in Asia countries even though their total fund sales increased during the global financial crisis. Fourth, spanning tests resulted in no rejection of the null hypothesis over small-cap funds in most countries. Thus, Koreans investments in international small-cap funds do not bring additional benefits to each country's index fund worldwide. The results were more strongly supported for the period from January 2003 to December 2010 than the previous period, from June 1994 to December 2002. Fifth, the Sharpe ratios of Korean investors' international fund investments were higher in the case of no-hedged risks for international exchange rate volatility than in case of fully-hedged ones. The correlations of fund returns among countries were also lower in the case of no-hedged risks from international exchange rate volatility. The results of spanning tests with no rejection of the null hypothesis over small-cap funds in most countries were more strongly supported in the case of no-hedged risks for international exchange rate volatility. Sixth, the analysis of variance decomposition for each country's small-cap fund return showed that the influence of global factor on the return and its variance greatly increased during the period from January 2003 to December 2010 compared to that from June 1994 to December 2002.
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