Comparative Determinants Of International Equity Diversification

This study provides a comprehensive, simultaneous comparison of the country and sector determinants of international diversification. Specifically, it bridges the theory between the cointegration methodology and diversification by linking market integration, cointegration and portfolio diversification. Cointegration tests are conducted to both analyze the stationarity of country and industry index covariances and to dissect the diversification contributions of each component. Portfolios comprised of market indices independent of cointegrating relations produce, on average, better risk-return profiles than those constructed from cointegrated market indices. Although country and sector allocations both contribute to independent market portfolio gains, the diversification determinants have differential impact on the components of portfolio risk. Additional tests affirm sector decisions provide stronger diversification gains than country allocation decisions. Finally, tests suggest institutional fund flows differentiate the performance of the independent and cointegrated portfolios. Mixed evidence suggests institutional flows may contribute to cointegrating relations although the effect is not pervasive.