International Portfolio Choice with Frictions: Evidence from Mutual Funds

Abstract

Using data on international equity portfolio allocations by U.S. mutual funds, we estimate a portfolio expression derived from a standard mean-variance portfolio model extended with portfolio frictions. The optimal portfolio depends on the previous month and the buy-and-hold portfolio shares, and a present discounted value of expected excess returns. We estimate expected return differentials and use them in the portfolio regressions. The estimates imply significant portfolio frictions and a modest rate of risk aversion. While mutual fund portfolios significantly respond to expected returns, portfolio frictions lead to a weaker and a more gradual portfolio response to changes in expected returns.