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Country ETFs, currencies and international diversification

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Abstract

Empirical evidence shows that market prices of country exchange traded funds (ETFs) react in unison with domestic stocks on their listing exchange to a common set of risk factors. This would argue against the use of indirect foreign investments via country ETFs to diversify a portfolio of domestic stocks. Using the net asset values of a cross-section of US and European-listed ETFs to control for market noise and time zone discrepancies, this study seeks to quantify the diversification benefits of country ETFs for a domestic investor. Moreover, fund returns are decomposed into their two fundamental drivers – the variations of the underlying foreign stocks and the foreign currency – in order to investigate the role of currency returns in modifying correlations between country funds and domestic stocks. To conclude, the analysis is repeated for the pre- and post-financial crisis periods to gain insight into shifts in the relationships between world equity markets since this dislocation.

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Notes

  1. As opposed to country funds, which only invest in stocks of a single country, international ETFs invest across countries or regions thereby presenting exposure to numerous foreign currencies.

  2. Country funds investing in China, Hong Kong and Malaysia are therefore eliminated from the research.

  3. Although the DJ Stoxx 600, which is quoted in euros, would be the equivalent broad measure of European equities, this index contains component stocks traded in sterling, francs and kronas. A currency-neutral measure of Euro-Zone equities is given by the Euro Stoxx index.

  4. www.ishares.com

  5. www.lyxoretf.fr

  6. Direct quotes indicate the number of dollars (or euros) per unit of foreign currency. In this way a numerical increase corresponds with an appreciation of the foreign currency.

  7. The traditional Pearson measure is given by, ρ NAV,D =(Cov(NAV,D))/(σ NAV σ D ), where Cov (NAV,D) is the covariance of the fund NAV and the domestic index returns, and σ NAV and σ D are the standard deviations associated with the tracker and index, respectively.

  8. Phillips–Perron (1988) unit root tests are also used to confirm the ADF tests.

  9. Complete test results are available from the author upon request.

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  1. Grenoble Ecole de Management, 12 Rue Pierre Sémard, Grenoble, 38000, France

    S Owen Williams

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  1. S Owen Williams
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Williams, S. Country ETFs, currencies and international diversification. J Asset Manag 15, 392–414 (2014). https://doi.org/10.1057/jam.2014.28

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  • DOI: https://doi.org/10.1057/jam.2014.28

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