The HFS Trustees have solicited input from three consultants concerning the risks and rewards of an allocation to international equities. Two of them strongly favor such action, while the third consultant commented as follows: “The risk reduction benefits of international investing have been significantly overstated. Recent studies relating to the cross-country correlation structure of equity returns during different market phases cast serious doubt on the ability of international investing to reduce risk, especially in situations when risk reduction is needed the most.”
a. Describe the behavior of cross-country equity return correlations to which the consultant is referring. Explain how that behavior may diminish the ability of international investing to reduce risk in the short run. Assume that the consultant’s assertion is correct.
b. Explain why it might still be more efficient on a risk/reward basis to invest internationally rather than only domestically in the long run.
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