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The Quest for Optimal Asset Allocation Strategies in Integrating Europe.

Extracts from this document...

Introduction

Bachelor Thesis International Business Administration: The Quest for Optimal Asset Allocation Strategies in Integrating Europe Faarnaz Chavoushi Erasmus University Rotterdam May 2004 Abstract: This paper examines the effect of the process of monetary and economic integration in the EMU on the optimal diversification strategies for the mean-variance optimising investor. Previous literature has mostly focused on the relative importance of country versus sector effects for the explanation of stock returns, but following Ehling and Ramos (2002) and Moerman (2003), this paper takes a more practical approach to the question at hand. It aims to directly investigate the evolution of the optimal diversification strategy since the establishment of the EMU. The methodology is based on the portfolio theory first introduced by Markowitz (1952), as well as the mean-variance spanning test initiated by Hubermann and Kandel (1987). The paper finds that different diversification strategies have been optimal in the four different subsample periods specified, and that no clear trend is to be detected, except that diversification over both industries and countries has always been superior. These two findings cast doubt on the traditional top-down allocation strategy which is widely been used by most investment institutions, and which conventionally focuses on geographical diversification in the first place. Moreover, the results also indicate that recent argumentation for a shift in diversification strategy after the introduction of the Euro towards industry allocation is not entirely correct from an economical/statistical perspective. OUTLINE OF CHAPTERS: 1. Introduction ...........................................................................................p.3 2. Research question....................................................................................p. 5 3. Modern Portfolio Theory ...........................................................................p.6 4. International diversification benefits within the EMU 4.1 Correlations among European stock markets..........................................p.9 4.2 Financial market integration in the EU................................................p.13 4.3 Country versus sector effects...........................................................p.20 4.4 Analysis of mean-variance frontiers...................................................p.24 5. Addition to the current body of knowledge...................................................p. 29 6. Methodology 6.1 Methodology..............................................................................p.30 6.2 Data.........................................................................................p.37 7. Main empirical results 7.1 Descriptive Statistics..................................................................p.40 7.2 Correlations..............................................................................p.42 7.3 Efficient frontiers.......................................................................P.49 8. Main conclusions...................................................................................p.53 9. References............................................................................................p.57 1. INTRODUCTION The issue of European stock market integration is of considerable importance to both investors and the economy as a whole. ...read more.

Middle

And although Ehling and Ramos (2002) use a more appropriate datasource, their sample period for the euro-period is rather short; only two years. Currently, we have more than five years of data available for the post-euro period. It would therefore be interesting to contribute to the discussion by extending the scope of the methodology of Ehling and Ramos (2002) and Moerman (2003) by conducting the research over a longer sample period. Furthermore, Datastream indices will be used to avoid the problem of high-capitalisation bias. Moreover, in order to capture the process of integration in the European stock markets, I perform the analysis over four subperiods, each indicating a different phase of economic integration in the European Union: the pre-convergence, convergence, pre-euro and euro era. An assessment of the optimal diversification strategy for each subperiod will be made to evaluate the consequences of the European integration process for the mean-variance optimising investor. By extending the sample period using more recent observations, and by overcoming the problem of high-capitalisation bias, I hope to be able to reconcile the findings of both studies and to reach a more unambiguous conclusion on the question of the optimal diversification strategies within the EMU. 6. METHODOLOGY AND DATA: 6.1 Methodology From the general research questions composed at the beginning of this research, and on the basis of the above mentioned literature, I have drawn a number of hypothesis which I would like to investigate further. Hypothesis 1: Correlations between EMU country indices are constant across the different subperiods. An increase in the correlation coefficients could indicate increased market integration over time, and a possible reduction of diversification benefits for a mean-variance optimising investor. Therefore, a comparison is made of the correlation coefficients among the country and industry indices over time to see whether there are significant changes in the four subperiods specified. To illustrate that the increase in average correlation trends is not heavily influenced by the figures of a few countries only, the following graphical analysis is conducted following Adjaoute and Danthine (2001). ...read more.

Conclusion

More recently, the argument is made that after the introduction of the Euro, the country orientation of the top-down approach should give way, within the euro-area at least, to an industry or sector orientation. The traditional top-down allocation strategy and the recent shift in paradigm may be questioned, because after all, the paper finds that different diversification strategies have been optimal in the four different subsample periods specified, and no clear trend is to be detected. Furthermore, this study has been unable to prove statistically that an industry allocation strategy has been superior after the introduction of the Euro (on the contrary!), so the current trend among institutional investors to restructure their asset allocation grid is not justified from pure economic/statistical perspective. Moreover, this paper clearly illustrates that diversifying over both countries and industries was the superior diversification strategy in all of the sub-periods. Nonetheless, most institutional investors in practice have always worked according to a top-down allocation grid, and even the recent calls for reform simply suggest replacing geographical distribution by industry diversification, instead of considering both opportunities simultaneously. According to Adjaoute et al (2003), costs are a major factor why the optimal two-step allocation strategy has not been implemented in the past. Two-step allocation is costlier than a one-step strategy, and so small players could possibly only afford one step. However, as recognised by the authors themselves, although costs might be a relevant factor in the contests of doing active portfolio management, they are hard to rationalise in the context of passive strategies. If institutional investors for any indeterminate reason wish to continue to apply a top-down allocation strategy, it is hard to make a recommendation for the optimal diversification strategy since this has seen to be subject to quite some change over time. Investors should note that there is no guarantee that diversifying over industries will permanently be the optimal investment strategy for the remaining future. As we have seen, covariances and correlations are rather volatile and indeed time-varying. This calls for a periodic revision of this research in the future for practitioners. 9. ...read more.

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