Review of Quantitative Finance and Accounting, 16, 311–321, 2001  C 2001 Kluwer Academic Publishers. Manufactured in The Netherlands. A Note on International Portfolio Diversification with Short Selling RAYMOND W. SO ∗ Department of Finance, Chinese University of Hong Kong, Shatin, Hong Kong YIUMAN TSE School of Management, Binghamton University, Binghamton, NY 13902-6015 Abstract. In this paper, the diversification benefits of using stock index futures are examined. Empirical evidence shows that traditional diversification in international equity markets does not produce a risk adjusted performance superior to the US market. An explanation for this result is that restrictions on short selling prohibit the best alloca- tion of resources when overseas stock markets are riskier and have worse returns. However, when such restrictions are eased for short selling in index futures markets, investors are enabled to both allocate their investments more efficiently and to construct a superior portfolio. Key words: international investment, portfolio diversification, shorting selling, index futures JEL Classification: G11, G15 1. Introduction Since the pioneering work of Grubel (1968), many studies (e.g., Levy and Sarnat, 1970; Solnik, 1974; Lessard, 1976; and Biger, 1979) have shown that international diversification can result in a lower level of risk for a given level of expected return. In addition, effectiveness of various international diversification strategies have also been examined extensively (e.g., Errunza, 1977; Errunza and Padmanabhan, 1988; Eun and Resnick, 1988; and Mathur and Hanagan, 1983). More recently, Bailey and Stulz (1990), Odier and Solnik (1993), Doukas and Yung (1993), Chang et al. (1995); Solnik (1995), Akdogan (1996), Michaud et al. (1996), Solnik (1997) and Griffin and Karolyi (1998) have shown that an internationally diversified portfolio is more efficient than other market portfolios in developed markets. In summary, extant empirical evidence in the past thirty years generally shows that global diversification is a viable strategy to pursue. Nevertheless, the increasing integration of financial markets, and the current superior per- formance of the US market, challenges the benefits gained from international diversification. ∗ Address correspondence to: Raymond W. So, Department of Finance, Chinese University of Hong Kong, Shatin, Hong Kong. Fax: +(852) 2603-6586, Email: rayso@cuhk.edu.hk