THE JOURNAL OF FINANCE * VOL. LIV, NO. 6 * DECEMBER 1999 Can the Gains from International Diversification Be Achieved without Trading Abroad? VIHANG ERRUNZA, KED HOGAN, and MAO-WEI HUNG* ABSTRACT We examine whether portfolios of domestically traded securities can mimic foreign indices so that investment in assets that trade only abroad is not necessary to exhaust the gains from international diversification. We use monthly data from 1976 to 1993 for seven developed and nine emerging markets. Return correlations, mean-variance spanning, and Sharpe ratio test results provide strong evidence that gains beyond those attainable through home-made diversification have be- come statistically and economically insignificant. Finally, we show that the incre- mental gains from international diversification beyond home-made diversification portfolios have diminished over time in a way consistent with changes in invest- ment barriers. THE BENEFITS OF INTERNATIONAL DIVERSIFICATION have been emphasized over the past 40 years by financial economists, who have shown that investing in foreign indices reduces the volatility of U.S. market portfolios, with gains attributed to low return correlations between national equity indices.1 Such investment in foreign indices requires holding securities that trade abroad, involving additional costs and potential barriers to international invest- ment. Yet, over the past 20 years, an increasing number of country funds and depository receipts have started trading in the U.S. that, along with shares of multinational corporations, can be used to gain benefits from in- ternational diversification. In this paper, we examine whether investors can take advantage of the gains of international diversification by forming a portfolio of securities that trade in the United States, and we find that this * Errunza is from McGill University, Montreal; Hogan is from Barclays Global Investors, San Francisco; and Hung is from National Taiwan University, Taipei. Our special thanks to Ren6 Stulz (the editor) and an anonymous referee for many insightful suggestions. We also thank Warren Bailey, Geert Bekaert, Jin-Chaun Duan, Campbell Harvey, Andrew Karolyi, Ken Kroner, Usha Mittoo, and Michael Rebello, Marcia Roitberg, and Jahangir Sultan for helpful comments. Research assistance from Carlton Osakwe and Yuxing Yan is gratefully acknowl- edged. The authors thank the Social Sciences and Humanities Research Council of Canada and the Faculty of Management at McGill University for financial support. We are grateful to the capital markets department of the International Finance Corporation for providing the data on emerging markets. 1 See, Solnik (1974), Errunza (1997), DeSantis and Gerard (1997), and Stulz (1997) for a detailed discussion of gains from international diversification. 2075 This content downloaded from 132.216.236.163 on Tue, 4 Nov 2014 15:00:11 PM All use subject to JSTOR Terms and Conditions