Partial Diversification May Enhance International Portfolio Return

Abstract

International stock portfolio returns are affected by exchange rate fluctuations. So, by reducing exposure to adverse exchange rate movements, portfolio returns may be improved. This study proposes an innovative international diversification strategy which restricts investments to countries whose currencies are not anticipated to depreciate according to deviations from purchasing power parity (PPP) accumulated over a five-year period. Using quarterly data from 1991 to 2006, performance of this strategy is examined for a number of investment horizons from the perspectives of eight developed countries with free-floating currencies. Depending on country perspectives, average returns realized by the proposed selective diversification strategy were 1.50 to 8.27 percent higher than those from the no-selection passive diversification strategy, a result which persisted after adjusting for risk. A portfolio return decomposition analysis shows that a major part of the strategy's excess return came from its superior currency-selection ability.