Factor Funds, Mean-Variance Efficiency, and the Gains From International Diversification

Factor Funds, Mean-Variance Efficiency, and the Gains From International Diversification

Eun, Cheol S., Lai, Sandy and Zhang, Zhe, (August 2007)

Abstract:

We propose a new investment strategy employing “factor funds” to systematically enhance the mean-variance efficiency of international diversification. Our approach is motivated by evidence from the empirical asset pricing literature and the direct link between factor-based asset pricing tests and investors' portfolio allocation problem. The success of size (SMB), book-to-market (HML), and momentum (MOM) factors in explaining stock returns and the country-specific properties of these factors imply that international factor funds can significantly enhance portfolio efficiency beyond what can be achieved by country market indices alone. Using data from ten developed countries over 1981-2004, we show that the Sharpe ratio of the “augmented” optimal portfolio involving international factor funds (0.76) far exceeds that of the “benchmark” optimal portfolio comprising country market indices only (0.19), strongly rejecting the intersection hypothesis which posits that the international factor funds do not span investment opportunities beyond what country market indices do. Among the three classes of factor funds, HML funds contribute most to the efficiency gains. The added gains from international factor diversification are significant for both in- and out-of-sample periods, and for a realistic range of additional investment costs for factor funds, and remain robust over time

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