Innocents Abroad:
Currencies and International Stock
Returns
Agenda
● Background and Meyer’s Philosophy
● Why Invest Internationally?
● Convincing the Client
● Calculations and Interpretation
● Optimal Portfolio
Case Background
● Sandra Meyer: Founder of CapGlobal Advisors, LLC.
● CapGlobal Advisors,LLC.
o Seven professionals focused in different areas of international portfolio
management
o Methodology focused on quantitative modeling and extensive research
on international markets
● Henry Bosse: CIO of the local state pension fund
● Client Concerns about International Strategy
o Might not really add much value to overall portfolio
o Might create unnecessary currency risks
Case Background
● Difficulty: hard to sustain investors’ attention in international stocks.
o When domestic market performs well;
why they were not fully invested in U.S.?
o When domestic markets sink;
why gains of their foreign exposures were often not large enough?
● Mission:
o The benefits of international diversification
o The impact of currency movements on returns of global portfolios
o The drivers and consequences of correlations among global equity
markets
Meyer’s Philosophy
Investing Internationally Adds Value to a Portfolio
● International diversification enhanced the returns that were possible for a
domestic investor
● International market returns can be achieved through both currency
movements and equity performance
Indices
● Domestic Index
○ S&P 500
● International Indices
○ EAFE
■ Morgan Stanley Capital’s Europe, Australasia,
and Far East Index
○ EM
■ MSCI Emerging Market Index
Why Invest Internationally?
● Increased expected returns and decreased standard deviation
● International stocks are just one of the five main asset classes and each
respond different to market cycles and events
o others are large-cap stocks, small-cap stocks, bonds, and cash
investments
● Increased exposure to more companies with unique products and
customer sets
● Added diversification with multiple currencies
● International stocks are becoming a larger share of the
investment universe
● Weather upturns and downturns differently
Why Invest Internationally?
● Boost returns with unique and emerging markets and currency variety
Unique: growth opportunities not available in the US
● Can be due to differences in household income, younger populations,
export strength, availability of natural resources, etc.
Emerging: developing countries experiencing rapid growth and industrialization
● Higher expected growth rates = higher potential returns
● Lower household income and lower debt levels allow for faster growth
● Higher risk alone, lower risk for portfolio due to diversification
● China, India, Brazil, and Russia
Why Invest Internationally?
Currency: currencies move relative to other currencies
● Adds a layer of diversification because currencies move in
different directions at different rates
● For greatest diversification benefit, exposure to international
equities should be unhedged
● When the US dollar declines, investments in other
currencies may boost returns; reverse is also true
o Examples
Currency Examples
December 1998:
Nikkei fell 4.43%, Yen appreciated against USD
8.56%, net return of 4.14% to US investors
March 2001:
Nikkei has 3.8% equity return, Yen depreciated
against USD 6.8%, return more than eliminated
Looking Forward
● IMF forecasts US growth at below the world growth in
coming years
● US’s importance and share of world economy has been
declining as emerging markets have grown in size
Meyer also sees the growth opportunities:
● EAFE and EM returns versus S&P 500 returns in 1993
o EAFE > S&P 500 by 22.82 points
o EM > S&P 500 by 28.86
Convincing the Client
● US equities have generally outperformed other
developed country equities
● Familiarity with domestic companies and
markets
● Easier to focus on only one market
● Emerging market equities are highly
volatile
Exhibit 1 Index Returns for the EAFE, EM and S&P 500 (in Native
Currency) from 1991 to 2013
Convincing the Client
● Alone, international investments are more risky due to added
currency risk
● Returns shown by foreign indices are a combination of currency
risk and equity risk which can be misleading
● Meyer must
o convince clients of the benefits of international diversification
o highlight the impact of currency movements on returns of
global portfolios
o explain the drivers and consequences of correlations
among global equity markets
Meyer’s Process
1. Examine international equity performance over a
considerable time frame: 1991-2013
2. Calculate monthly returns for the markets: Australia,
Canada, China, Germany, India, Japan, United Kingdom,
and United States
3. Compare the returns and calculate average monthly
returns and standard deviations in 10 and 11 year sub-
periods
4. Annualize all returns and standard deviations
Meyer’s Process
5. Calculated correlations of returns based on local currency and
USD (for 1991-2013, 1991-2001, and 2002-2013)
6. Decomposition of Foreign Stock Market Returns to U.S. Investors
relative to the S&P 500 into returns based on equity and returns
based on currency
7. Allocate return foreign equity and foreign currency by comparing
returns based on the EAFE and EM indices with the S&P 500
Results of Returns and Standard Deviations
For Returns
● Low
● Medium
● High
Native Currency Based Annualized Returns and Standard Deviations over 1991-2013, 1991-2001 and 2002-2013
For S.D.
● High
● Medium
● Low
U.S. Dollar Based Annualized Returns and Standard Deviations over 1991-2013, 1991-2001 and 2002-2013
Correlation Table of Native Currency
Based Returns
1991-2013
● Low
1991-2001 ● Medium
● High
2002-2013
Correlation Table of Dollar Based
Returns
1991-2013
● Low
1991-2001 ● Medium
● High
2002-2013
Decomposition of Foreign Stock Market Returns to
U.S. Investors relative to the S&P 500
EM Return
(native currency 71.05%
based index)
EM Return
(dollar based index) 28.80%
S&P 500 Return 30.47%
EM Return to US Investor relative to S&P 500: 28.80% - 30.47% = -1.67%
Contribution of foreign equity return: 71.05% - 30.47% = 40.58%
Return on foreign equities relative to S&P 500:
Contribution of foreign currency return: -1.67% - 40.58% = -42.25%
EM Return to US Investor less foreign equity return:
Table A EM Returns to U.S. Investors Relative to the S&P 500: Contribution
by Foreign Equity Returns and Foreign Currency Returns in 1991
Calculating Figures
Correlation Coefficient
Average Returns Std. Dev. of Returns
and Covariance
S&P 500 and EAFE S&P 500: 10.83 % S&P 500: 18.688 % rho: 0.77053
1991-2013 EAFE: 6.59 % EAFE: 18.568 % Cov: 0.02674
S&P 500 and EAFE S&P 500: 15.64 % S&P 500: 17.134 % rho: 0.59736
1991-2001 EAFE: 8.14 % EAFE: 15.156 % Cov: 0.01551
S&P 500 and EAFE S&P 500: 6.03 % S&P 500: 19.723 % rho: 0.89399
2002-2013 EAFE: 5.03 % EAFE: 22.113 % Cov: 0.03899
Calculating Figures
Correlation Coefficient
Average Returns Std. Dev. of Returns
and Covariance
S&P 500 and S&P 500: 10.83 % S&P 500: 18.688 % rho: 0.75136
EAFE$ 1991-2013 EAFE$: 7.94 % EAFE$: 20.398 % Cov: 0.02864
S&P 500 and S&P 500: 15.64 % S&P 500: 17.134 % rho: 0.56547
EAFE$ 1991-2001 EAFE$: 6.73 % EAFE$: 17.115 % Cov: 0.01658
S&P 500 and S&P 500: 6.03 % S&P 500: 19.723 % rho: 0.94582
EAFE$ 2002-2013 EAFE$: 9.14 % EAFE$: 24.034 % Cov: 0.04483
International Diversification -
Yes or No?
● In most cases international diversification
reduces risk
● Taking currency movements into consideration
is crucial
● The assumption that riskier investments yield
higher returns is not true in this case
Efficient Frontier Basics
● Investors
o Non-satiation: better returns
o Rational: logical decisions
o Risk aversion: compensation for risk
o Mean-variance: decisions based on only return and risk
● Results
o Minimize risk for a given expected return
o Maximize return for a given risk
● “Efficient”
o When there is no other asset or portfolio that offers a higher
expected return with the same (or a lower) risk
o Upper half of the curve: above the minimum variance portfolio
on the portfolio frontier
