International diversification: The weighting is the hardest part

Abstract

Many traditional, international diversification approaches do not address the influence of economic integration and corresponding market correlations across countries. The authors develop a trade-adjusted weighting methodology that reduces the effect of economic integration on portfolio performance. Results demonstrate that the trade-adjusted portfolio outperforms a GDP-weighted portfolio in terms of risk-adjusted returns. Likewise, the trade-adjusted portfolio's performance exceeds that of an equally weighted portfolio in most risk-adjusted measures. These results provide a strong argument for investment managers to use trade-adjusted weightings in forming portfolios and developing financial products.