International diversification during the financial crisis: A blessing for equity investors?

This paper empirically investigates international equity investors' foreign portfolios before and during the financial crisis by estimating a gravity model for 22 source and 42 destination countries during 2001-2009. The results show a significant negative relationship between foreign equity holdings and stock market correlations during the financial crisis, while there is no relationship before the crisis. When distinguishing between active and passive rebalancing, the results clearly indicate a significantly negative relationship between active rebalancing and correlations during the crisis. These findings hold as well at the individual country level when allowing for source country specific coefficients. An analysis from the perspective of each source country's representative investor, who optimizes mean-variance utility, shows that active rebalancing provides sizeable utility gains during the crisis. Finally, there is even a significantly negative relationship between future correlations and active rebalancing since 2007, suggesting that prior to the crisis investors already repositioned their country weights to markets with lower correlation during 2008-2009.