International Investing and China in the NBER Digest

I came across a couple of interesting items in the July issue of the National Bureau of Economic Research's NBER Digest.

The first item that caught my eye was The Declining Gain from International Portfolio Diversification (by Les Picker). That article describes a NBER Working Paper by Karen Lewis, a financial economist at Wharton, where she examines the puzzle of why investors tend to disproportionately weight their investment portfolios to domestic securities and assets. This tendency is a 'puzzle' because this tendencymeans that investors forego the possible gains -- including lower correlated risks, higher returns from riskier foreign investments, etc. -- from international diversification.

Prof. Lewis finds that (a) international equity markets have become more correlated over the years (although she didn't find them to be as highly correlated as others have suspected them to be), and (b) foreign stocks that are listed on U.S. exchanges have become highly correlated with the U.S. market(s) over time. Thus, the potential gains from international portfolio diversification have been declining, and there seems to be relatively little to be gained in the way of diversification from investing in domestically listed foreign stocks.

The second item of interest in the NBER Digest is The Return to Capital in China (also by Les Picker). This article discusses research by professors Bai, Hsieh, and Qian, on what affects (if any) China's high investment rate (over 40% of GDP) has on returns to capital. The researchers found that (adjusted for various factors) China has relatively high returns to capital. It should be noted that this is an interesting finding because high investment rates can often mean lower returns to capital.

One of the plausible reasons why China's return to capital seems to be higher is -- despite misallocation of capital in many cases -- that China's economy has been moving rapidly toward more capital-intensive industries and techniques and away from purely labor-intensive industries of the past.

Timber! Money Can Grow on Trees

A few years ago, I came across an alternative asset class that institutional investors -- especially university endowments -- that struck me as being really out-of-the-box: timberland. At the time, I asked myself, "Why are sophisticated investors investing in trees and forests?"

A recent New York Times article, For Some Investors, Money Grows on Trees (May 27, 2007), answered many of the questions I had about this alternative investment. In a nutshell, investors are counting on revenues from sales of timberland products to lumber, paper, and other companies, along with potential gains from the underlying real estate. Rather than investing in individual lots (which would make little sense for large institutional investors like pension funds and university endowments), investors invest through TIMOs (timber investment management organizations) and timber REITs (real estate investment trusts).

Historically, investing in timber has done well. An index of returns on timberland investments since 1986 (when the index was created) to the first quarter of this year rose at an annualized rate of 15.09%. In the last three years, the return was 14.63%, which is higher than the returns on the S&P 500 over that period (12.25%).

The most appealing aspect of this asset class is that it has had low correlation with the performance of stocks and bonds. 'Low correlation' is important to risk management under conventional financial economics portfolio theory. I should note that that I am usually highly skeptical and suspicious of claims of 'low correlation' between asset classes and markets since 'correlations' are (a) dynamic, and (b) there might be less obvious links between investments that simple measures of correlation don't pick up. However, in this case, this idea does seem to pan out at this point in time.

Note: The best books I'm aware of dealing with the role that alternative assets can play in managing an investment portfolio are the two books written (thus far) by David Swensen. I'm not sure if Yale's endowment invests in timberland, but I would be shocked if they didn't. I am aware of other university endowments that do invest in timberland, e.g., Caltech.