US Risk in a Global Setting

1
Global Asset Allocation and Stock Selection
Global Asset AllocationThe Case For
International Investment
Campbell R. Harvey Duke University, Durham, NC
USA National Bureau of Economic Research,
Cambridge MA USA Cam.harvey_at_duke.edu 1
919.660.7768 office 1 919.271.8156
mobile http//www.duke.edu/charvey
2
The Plan

• International track record
• Returns and diversification
• Long horizon vs. short horizon
• What can we expect from U.S. equities?
• What to expect from international?
• Alternative views dynamic strategies, hedge
  funds
• Research frontier changing views of
  diversification
• Importance of GPR

3
The International Track Record
U.S. Investments Versus Non-U.S. Equities
Wilshire Mid Cap
Thirty Year Treasury STRIP
Twenty Year Treasury STRIP
Wilshire Large Cap
Wilshire 5000
Ten Year Treasury STRIP
Wilshire Small Cap
EAFE X-Japan
Seven Year Treasury STRIP
Credit
MBS
Five Year Treasury STRIP
Aggregate
Government
EAFE
Three Year Treasury STRIP
Two Year STRIP
One Year Treasury STRIP
Source Erb and Harvey (2004)
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Returns and Diversification
Data from MSCI
5
Returns and Diversification
Data from IFC
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Returns and Diversification
Data from MSCI
7
Returns and Diversification
Data from MSCI
8
Returns and Diversification
Data from MSCI
9
Returns and Diversification
Data from MSCI
10
Returns and Diversification
Data from IFC
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Returns and Diversification
Data from MSCI
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Returns and Diversification
Data from IFC
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Returns and Diversification
Data from IFC and MSCI
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The Long Horizon
Data from Dimson, Marsh and Stauton (2002)
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The Long Horizon
Data from Dimson, Marsh and Stauton (2002)
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The Long Horizon
Data from Dimson, Marsh and Stauton (2002)
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The Long Horizon
Data from Dimson, Marsh and Stauton (2002)
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What to Expect
Data from Dimson, Marsh and Stauton (2002)
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What to Expect
Source Goldman Sachs (2002)
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What to Expect

• Ten-year risk premium around 3.5 and stable
  whereas one-year risk premium quite variable

10-year premium
1-year premium
Source Graham and Harvey (2005)
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What to Expect
U.S. Equity and Bond Returns are Positively
Correlated
Source Erb and Harvey (2004)
22
What to Expect
World Real Equity and Real Bond Returns are
Positively Correlated
Source Erb and Harvey (2004)
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What to Expect
Inflation Negatively Related to Real Bill Returns
Source Erb and Harvey (2004)
24
What to Expect
Inflation Negatively Related to Real Intermediate
Bond Returns
Source Erb and Harvey (2004)
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What to Expect
Inflation Negatively Related to Real Bond Returns
Source Erb and Harvey (2004)
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What to Expect
Inflation Negatively Related to Real Equity
Returns
Source Erb and Harvey (2004)
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What to Expect
Inflation Negatively Related to Real
International Bill Returns
Source Erb and Harvey (2004)
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What to Expect
Inflation Negatively Related to Real
International Bill Returns
Source Erb and Harvey (2004)
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What to Expect
Inflation Negatively Related to Real
International Equity Returns
Source Erb and Harvey (2004)
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What to Expect
Inflation Negatively Related to Real
International Equity Returns
Source Erb and Harvey (2004)
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Alternative Vehicles
Alternate Asset Classes Often Involve Implicit or
Explicit Options
Source Naik (2002)
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Alternative Vehicles
Alternate Asset Classes Often Involve Implicit or
Explicit Options
Source Naik (2002)
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Alternative Vehicles
Alternate Asset Classes Often Involve Implicit or
Explicit Options
Source Naik (2002)
34
Alternative Vehicles
Alternate Asset Classes Often Involve Implicit or
Explicit Options
Source Naik (2002)
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Alternative Vehicles
Alternate Asset Classes Often Involve Implicit or
Explicit Options
Source Figure 5 from Mitchell Pulvino (2000)
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Alternative Vehicles
Alternate Asset Classes Often Involve Implicit or
Explicit Options
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4
2
0
-15
-10
-5
0
5
10
Event Driven Index Returns
-2
-4
LOWESS fit
-6
-8
Source Naik (2002)
Russell 3000 Index Returns
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Rethinking Risk

• Traditional models maximize expected returns for
  some level of volatility
• Is volatility a complete measure of risk?

38
Rethinking Risk

• Much interest in downside risk, asymmetric
  volatility, semi-variance, extreme value
  analysis, regime-switching, jump processes, ...

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Rethinking Risk

• ... These are just terms that describe the
  skewness in returns distributions.
• Most asset allocation work operates in two
  dimensions mean and variance -- but skew is
  important for investors.
• Examples

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Rethinking Risk

• 1. The 1 lottery ticket. The expected value is
  0.45 (hence a -55) expected return.
• Why is price so high?
• Lottery delivers positive skew, people like
  positive skew and are willing to pay a premium

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Rethinking Risk

• 2. High implied vol in out of the money OEX put
  options.
• Why is price so high?
• Option limits downside (reduces negative skew).
• Investors are willing to pay a premium for assets
  that reduce negative skew

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Rethinking Risk

• 3. Some stocks that trade with seemingly too
  high P/E multiples
• Why is price so high?
• Enormous upside potential (some of which is not
  well understood)
• Investors are willing to pay a premium for assets
  that produce positive skew
• Note Expected returns could be small or
  negative!

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Rethinking Risk
Source Harvey and Siddique (2000)
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Rethinking Risk
Data from MSCI
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Rethinking Risk
Data from IFC
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U.S. Has Become a Riskier Global Investment

• The U.S. has become much more risky
• High sensitivity to some GPRs
• Disagreement on strength of economy
• Financial information less credible
• These factors suggest shifting exposures from
  equity to safer fixed income

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U.S. Has Become a Riskier Global Investment
ICRG Political Risk
Data from PRS
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U.S. Has Become a Riskier Global Investment
ICRG Political Risk
Data from PRS
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U.S. Has Become a Riskier Global Investment
ICRG Political Risk
Data from PRS
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U.S. Has Become a Riskier Global Investment
Risk Ratings December 2002
Data from PRS
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U.S. Has Become a Riskier Global Investment
Risk Ratings May 2001
Data from PRS
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U.S. Has Become a Riskier Global Investment
Higher risk means equity investors require a
higher rate of return
Risk Ratings from Institutional Investor
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U.S. Has Become a Riskier Global Investment

• Equation implies an increase in the medium-term
  risk premium of 240bp
• This helps explain the recent decline in the
  equity market
• This helps explain the recent behavior of the
  U.S. dollar
• This helps explain the slow down in real
  investment (hurdle rates are up)

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Conclusions

• International investment is mainly about returns
  diversification, while important, is often
  oversold
• Expected returns depend on fundamental values
  today not just historical return performance.
• U.S. risk has increased suggesting a reallocation
  from equity to fixed income

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Readings

• All articles on www.duke.edu/charvey
• The Drivers of Expected Returns in International
  Markets (2000)
• Global Tactical Asset Allocation (2001) with
  Magnus Dahlquist
• The Term Structure of Equity Risk Premia (2004)
  with Claude Erb