1 International Diversification and Return Predictability: Optimal Dynamic Asset Allocation

According to standard mean-variance analysis, international diversification should produce benefits for an investor because of the potential for risk reduction due to the low correlations between stock markets in different countries. However, the empirical and statistical evidence is very mixed. On the other hand, there is growing evidence that lagged global and local economic indicators are capable of predicting international stock returns. The goal of this paper is to construct dynamically efficient strategies that utilize this predictability to achieve optimal in-ternational diversification, and study their performance. We draw three main conclusions from our empirical findings. First, there are potentially large economic benefits of international diversification in the presence of predictive information, in sharp contrast to the traditional fixed-weight case. Second, the use of country-specific indicators in addition to global variables further improves portfolio performance. Third, dynamically efficient strategies perform much better, while incurring lower transaction costs than traditional myopically optimal strategies, which have been the focus of most previous research. All our findings are statistically signifi-cant