Waiter! Is the Free Lunch of International Diversification Still on the Menu? A Most Diversified Portfolio Approach to Asset Allocation

Filip Jedmo & Emil Palmgren

Student thesis: Master thesis


In this study we extend the research on risk-based asset allocation strategies. We build upon the work by Choueifaty & Coignard (2008) and Choueifaty et al. (2011) who developed the approach of the Most Diversified Portfolio (MDP) which seeks to maximize the diversification ratio, a measure of diversification benefits. Choueifaty et al. (2011) state that the MDP “…is a strong candidate for being the undiversifiable portfolio, and as such delivers investors the full benefit of the equity risk premium”, by which they mean the portfolio which maximizes the risk-adjusted return. We use this framework to study international investing from a purely risk-based perspective. This allows us to deviate from previous research on international investing who have studied the subject from a mean-variance framework, a framework that has been questioned and fallen out of favor in recent years. We use MSCI equity indices of 23 developed markets and 28 emerging markets over the time-period 1988-2019 as a reference universe. Our findings indicate the MDP portfolio outperforms both a market cap-weighted and equally-weighted portfolio. This allows us to state that the strategy delivers on the outperformance claims made in Choueifaty et al. (2011). After establishing the relevance of a focus on the diversification ratio as a tool for studying international investing, we set out to find the driving factors behind it. To do so we conduct a regression analysis to link the diversification ratio with economic variables measuring time-varying levels of integration between the countries included in our reference universe. The variables used are (1) trade linkages, measured by bilateral trade, (2) financial integration, measured by external liabilities and (3) recessions, determined by the National Bureau of Economic Research (NBER). We find that increased trade linkages and the financial integration of emerging markets have a significantly negative impact on diversification ratios. Furthermore, we find that the 1990 and 2001 recessions during the period studied differently impact the different market segments, thus highlighting the benefits of holding a global portfolio. Contrary to this we find diversification benefits fall apart for all globally invested portfolios during the global financial crisis 2008 with the MDP delivering the least bad diversification benefits throughout the period.

EducationsMSc in Finance and Investments, (Graduate Programme) Final Thesis
Publication date2020
Number of pages127