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Optimization, cointegration and diversification gains from international portfolios: an out-of-sample analysis

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Abstract

This study investigates comparative performance of iShares and their underlying market indices in a portfolio context from the perspective of U.S. investors. Two aspects are important. First, portfolios based on standard optimization procedures and a portfolio based on cointegration procedures are created and out-of-sample performance is compared. The portfolio utilizing cointegration inputs shows superior out-of-sample performance. Second, portfolio performance measurement is extended to different holding periods. The findings do not differ.

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Notes

  1. This specification is validated through G(r) statistics based on the procedure in Johansen (1994). The test statistics are not shown, but are available upon request.

  2. Since the stock markets under investigation might be subject to financial shocks and crises during the estimation period, we perform additional cointegration tests that explicitly account for the 1992–1993 European currency crisis and for the 1997–1998 Asian financial crisis by incorporating a time dummy into the cointegrating relationships. The cointegration test results do not differ from those without a time dummy. Thus, effects of financial shocks and crises on stock markets are likely temporary. They do not significantly affect cointegrating relationships (which are long-run in nature) nor related implications on long-term portfolio performance. Results of cointegration tests with a time dummy are not shown, but are available upon request. We are thankful for the referee for asking us to investigate the effects of financial shocks and crises on cointegrating relationships.

  3. In other words, for a short holding period, the diversification benefit reduction resulting from high correlation may dominate the diversification benefit enhancement resulting from the absence of cointegration. Longer time spans are needed for the diversification benefit enhancement from no cointegration to be dominant. This further implies that the cointegration-based portfolio selection may not be applicable for a short holding period that may include a financial crisis during which correlation among markets tends to be very high. We are thankful for the referee for raising these important points regarding short-term investment horizons.

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Authors and Affiliations

  1. Department of Finance, California State University, Long Beach, 1250 Bellflower Boulevard, Long Beach, CA, 90840, USA

    Chanwit Phengpis

  2. Department of Finance and Real Estate, The University of Texas at Arlington, UTA Box 19449, Arlington, TX, 76019, USA

    Peggy E. Swanson

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  1. Chanwit Phengpis
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  2. Peggy E. Swanson
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Correspondence to Peggy E. Swanson.

Appendix

Appendix

Appendix Performance tests of portfolios 2 and 3 with equal-weight allocation (2000:08–2006:12)
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Phengpis, C., Swanson, P.E. Optimization, cointegration and diversification gains from international portfolios: an out-of-sample analysis. Rev Quant Finan Acc 36, 269–286 (2011). https://doi.org/10.1007/s11156-010-0174-3

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