Tandelilin—Gains from International Diversification and Domestic Portfolio in...
Gadjah Mada International Journal of Business
September 1999, Vol. 1, No. 2, pp. 63—84

GAINS FROM
INTERNATIONAL DIVERSIFICATION AND
DOMESTIC PORTFOLIO
IN EMERGING STOCKS MARKETS:
PHILIPPINE AND INDONESIAN
PERSPECTIVES
Eduardus Tandelilin
The study was organized into two major concerns: first, identifying the
gains from international diversification in emerging stock markets from the
Philippine and the Indonesian perspectives and determining which perspective yields the greater gains; and second, determining how many
securities must be included to obtain an optimal investment portfolio from
the Philippine and Indonesia perspectives.
The empirical results indicate that there are gains from international
diversification, both from the Philippine and Indonesian perspectives, in
two to eight emerging stock markets. Generally the gains are greater from
the Indonesian perspective than the Philippine perspective in all country
combinations.
Further, this study found that the number of stocks needed to form an
optimum domestic investment portfolio was bigger for the Indonesian
investor‘s perspective (at 15 stocks) than for the Filipino investor (14).
Keywords: characteristics; multinational; performance; U.S.

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Gadjah Mada International Journal of Business, September 1999, Vol. 1, No. 2

Introduction
Background of the Study
The benefits from portfolio diversification have been of increasing interest to
both investment professionals and academicians. Since the fortunes of different
nations do not always move together, investors can diversify their portfolio by
holding assets in several countries (French
and Poterba 1991). According to Michaud,
Bergstrom, and Frashure (1996), international equity portfolio diversification is
now well accepted by investors around the
world. Foreign diversification has been
accepted as a means of improving portfolio efficiency through risk reduction
(Solnik 1995; Ziobrowski and Ziobrowski
1995; Odier and Bruno 1995; Eun and
Resnik 1994; Madura and Soenen 1992;
Haavisto and Hannson 1992; Divecha et.
al. 1992; Speidell and Sappenfield 1992;
Francis 1991; Levy and Lerman 1988;
Levy and Sarnat 1970; among others).
As a result of current aggressive financial market globalization, investors
shifted their investment strategies to emerging stock markets away from the more
developed countries (Errunza 1994). The
Asian Pacific stock markets have been
cited as alternative financial interests for
international diversification strategies because of their significant developments.
According to Pudjiastuti and Husnan
(1994), investing in Asian Pacific stock
markets is a very effective way of reduc-

ing risk, from the U.S. investors’ point of
view, mainly because the correlation between foreign exchange (i.e. the U.S. dollar) changes and market index changes in
some markets is negative. This implies
that international diversification of portfolios is instrumental in reducing risk.
Moreover, the correlation between market
returns in those markets, denominated in
U.S. dollars, is very low or even negative.
Recently, however, the issue of
emerging stock markets has become more
heated. According to the International Finance Corporation (IFC), all stock markets in developing countries are considered as emerging stock markets,1 where
most of the low and the middle income
economies are classified as developing
economies or countries.
So far, developed countries have been
the focus of studies on international diversification. Thus, empirical studies were
mainly on developed capital markets such
as the United States. The current study,
which focuses on developing countries
like the Philippines and Indonesia and
touches other emerging markets such as
Thailand, Malaysia, Taiwan, South Korea, Pakistan, and India, may be able to
contribute to the limited literature on international diversification among developing countries.
Furthermore, several writers have also
studied the relation between the riskiness
of a portfolio assembled in a home country
and the number of securities included.
Solnik (1995) showed that risk can be

1
Emerging markets can be defined in different ways. The “emerging market” implies that a market has
begun a process of change, growing in size and sophistication, in contrast to markets that are small and give little
appearance of change. The term can also refer to any developing economy, with the implication that all have the
potential for development. International Finance Corporation (IFC) follows this latter definition. Just as most
of the low-and the middle-income economies are considered to be developing, regardless of their particular stage
of development, all stock markets in developing countries are considered to be emerging. IFC follows the criteria
of the World Bank in classifying economies as low-income, middle- income and high-income (Emerging Stock
Markets Factbook 1996, International Finance Corporation, p. 2).

64

Tandelilin—Gains from International Diversification and Domestic Portfolio in...

substantially reduced through diversification in domestic common stocks. This
study provides an analysis of the optimal
number of stocks needed to achieve a
more effective and reasonable diversification at low cost. A risk-averse investor
seeking to improve investment performance will learn the important distinction
between diversifiable risk and nondiversifiable risk. Newbould and Poon
(cited by Colley 1996) recommended that
a portfolio of between eight and twenty
stocks is the minimum necessary to eliminate diversifiable risk. This paper explores
the extent of the benefits of diversification
of stock securities in emerging stock markets from the Philippine and Indonesian
perspectives.

Objectives of the Study
Numerous studies have discussed the
benefits of international diversification
particularly among the developed stock
markets (e.g., Solnik 1995; Ziobrowski
and Ziobrowski 1995; Odier and Bruno
1995; Eun and Resnik 1994; Madura and
Soenen 1992; Haavisto and Hannson 1992;
Divecha, et. al. 1992; Speidell and
Sappenfield 1992; among others). However, studies focusing on emerging stock
markets, specifically the Philippine Stock
Market and the Indonesian Stock Markets
are limited. A study on the emerging stock
markets like the Philippine and Indonesian experiences will be able to provide
additional evidence in this area of concern.
The central purpose of this study is to
focus on the emerging stock markets, particularly the Philippine Stock Exchange
(PSE) and the Jakarta Stock Exchange
(JSX) in terms of diversification. Specifically, this paper aims to answer the following questions:

1. Are there gains from international diversification in emerging stock markets (Thailand, Malaysia, Taiwan, South
Korea, Pakistan and India) from the
Philippine and the Indonesian perspectives? Where are the gains greater?
2. How many securities must be included
to obtain an optimal investment portfolio from the Philippine and Indonesian
perspectives?

Review of Related Literature
Although several empirical studies
have shown the benefits of international
diversification of portfolios, no study has
been done on the Philippine and Indonesian perspectives. The closest related literature was an empirical survey of Indonesian equities (1985-1992) by Richard Roll
in 1995. Using a new database of equities
listed in the Jakarta Exchange, historical
returns were documented for the 19851992 period. He found that Jakarta stocks
had high volatility relative to other countries and Jakarta’s value stocks (those with
low market/book value ratios) performed
much better than growth stocks.
In terms of international diversification, Greenwood (1993, as cited by
Lamberte 1994) made some estimations
with regard to investment in stocks. It was
estimated that with a 60 percent U.S. and
40 percent Far East ex-Japan portfolio,
returns can be increased by 1.5 percent per
annum for the same level of risk, or alternatively, with an 80 percent U.S. and 20
percent Far East ex-Japan portfolio, returns can be raised by 0.75 percent per
annum while risk can be reduced.
Similarly, the gains from international
diversification of investment portfolios
from the Japanese as well as the U.S.
perspectives were analyzed by Eun and

65

Gadjah Mada International Journal of Business, September 1999, Vol. 1, No. 2

Resnick (1994). Their major findings were:
(1) the potential gains from international,
as opposed to purely domestic, diversification, are much greater for U.S. investors
than for Japanese investors; for U.S. investors, the gains accrue not so much in
terms of lower risk as in terms of higher
return, the opposite holds for Japanese
investors; (2) using various ex-ante international investment strategies designed to
control parameter uncertainty, U.S. investors can realize substantial gains from international diversification; and (3) hedging exchange risk generally allows U.S.
investors, but not Japanese, to benefit more
from international diversification.
The benefits of international diversification were further examined over time
by Madura and Soenen (1992). They compared different investors’ perspectives and
suggested that Japanese investors were
likely to benefit from international diversification. On an inter-temporal basis, the
risk characteristics improved the most for
the Swiss perspective and worsened for
the U.S. perspective. These research results prove that gains from international
diversification continue to exist regardless of the country perspective. Thus, there
is no conclusive evidence that the gains
from international diversification decrease
over time.
On the other hand, Haavisto and
Hansson (1992) analyzed potential gains
from international diversification for different Nordic investors (Danish, Finnish,
Norwegian and Swedish) if they invested
in all the Nordic equity markets. Three
interesting empirical results were obtained
from the study. First, it was shown that for
an investor with a long investment horizon, the exchange rate risk was negligible.
Second, the derivation of the ex post effective frontier suggests that there would have
been ample scope for actually reducing
66

risk by Nordic diversification. Third, the
ex post optimal portfolios were extremely
concentrated and included in general only
Finnish and Swedish assets, which is an
indication of segmented markets. The study
concluded that for the period under consideration, a long-term investor would have
done very well by keeping a non-hedged
and diversified Nordic portfolio.
In international diversification, it is
important to consider domestic conditions.
Domestic securities tend to move up and
down together because they are similarly
affected by domestic conditions, such as
money supply announcements, movements
in interest rates, budget deficit and national growth (Solnik 1996). These create
the strong positive correlation among all
domestic stocks traded in the same market. Foreign capital stock markets, because they are not affected by these, provide a way for domestic residents to diversify their portfolios internationally (Solnik
1996, Ziobrowski and Ziobrowski 1995;
Elton and Gruber 1994; Bart 1992; Divecha
et al. 1992; and Speidel and Sappenfield
1992).
Recently, Solnik (1995) showed that
substantial advantages in risk reduction
can be attained through portfolio diversification in foreign securities as well as in
domestic common stocks. The total risk of
a portfolio will depend not only on the
number of securities included in the portfolio, but also on the riskiness of each
individual security and the degree to which
these risks are independent.
In another perspective, Cosset and
Suret (1995) studied the benefits of portfolio investment in the stock markets of
politically risky countries by evaluating
the effects of political risk constraints on
the performance of a portfolio of international stocks. They used ex post and exante portfolio selection strategies which

Tandelilin—Gains from International Diversification and Domestic Portfolio in...

were developed to assess the gains from
international diversification. In light of
their empirical findings, they suggested
that diversification among politically risky
countries improves the risk-return characteristics of optimal portfolios.
In 1992, Brainard and Tobin studied
internationalization of portfolios and observed that optimal portfolio diversification lowers the risk premia. However, they
noted that the risk-free rate was raised by
more than the reduction in the risk of
premium, hence, the rate of return on foreign equity also rises. Bart (1992) had
similar observations. He indicated that
diversification helps investors minimize
the risks that arise from unforeseen developments in the world economy, the national economy, competition and corporate management. He concluded that to
achieve maximum risk-reduction, it is necessary to create a mix of securities whose
returns do not move up and down together
in response to the same developments.
Risk is further reduced by introducing
stocks from different countries under economic conditions that are different from
those in the investor’s home country.
Moreover, several writers have also
studied the relations between the riskiness
of a portfolio assembled in a home country
and the number of securities included.
Solnik (1995) showed that risk can be
substantially reduced through diversification in domestic common stocks. This
study provides an analysis of the optimal
number of stocks needed to achieve a
more effective and reasonable diversification at low cost. A risk-averse investor
seeking to improve investment performance will learn the important distinction
between diversifiable risk and nondiversifiable risk. Newbould and Poon
(cited by Colley 1996) recommended that
a portfolio of between eight and twenty

stocks is the minimum necessary to eliminate diversifiable risk. This paper explores
the extent of the benefits of diversification
of stock securities in emerging stock markets from the Philippine and Indonesian
perspectives.

Methodology
The focus of the study is mainly on
portfolio diversification in Asian emerging stock markets, with emphasis on the
Philippine and Indonesian stock markets.
A conceptual framework is developed to
show the logical flow of analysis and the
significant variables in the study. The conceptual framework generally shows that
gains from international diversification
depend on returns, standard deviation and
correlation of stock return index for each
country. On the other hand, gains from
domestic diversification generally depend
on the returns, standard deviation and correlation of stocks. These were basically
analyzed from the Philippine and Indonesian perspectives. In this framework, potential gains from international diversification by investors from both countries are
compared.
The Philippine and Indonesian stock
markets are used to test the validity of this
framework. Figure 1 represents the conceptualized framework.
The conceptual framework involves
two (2) major areas. First, it deals with
international diversification by analyzing
eight (8) emerging stock markets. These
are the Philippines, Indonesia, India, Malaysia, Pakistan, South Korea, Taiwan,
and Thailand. The stock price indices of
each country were considered to be able to
determine the potential gains from international diversification, both from the Philippine and Indonesian perspectives. The
result will be the basis for determining
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Gadjah Mada International Journal of Business, September 1999, Vol. 1, No. 2

Figure 1. Conceptual Framework

PHILIPPINE AND
INDONESIAN
PERSPECTIVES
1

2

INTERNATIONAL
DIVERSIFICATION
INVOLVING
SELECTED
EMERGING STOCK
MARKETS:
Philippines, Indonesia,
India, Malaysia,
Pakistan, South Korea,
Taiwan, Thailand

CORRELATION

STANDARD
DEVIATION

DOMESTIC
PORTFOLIO
INVOLVING
SELECTED
PHILIPPINE AND
INDONESIAN
STOCKS:
30 Philippine Firms
30 Indonesian Firms

RETURNS

RETURNS

STANDARD
DEVIATION

CORRELATION

GAINS FROM
DIVERSIFICATION
SHP=ME/SD

which perspective yields the greater gains.
Second, the framework presents an analysis of domestic portfolio by determining
the gains based on relative returns and
standard deviations (or termed as Sharpe
ratio) for randomly selected portfolios from
the Philippines and Indonesia. Comparison was made between the Philippine and
Indonesian portfolios in terms of the number of stocks needed for an optimal investment portfolio.
The sample, aside from the main focus of the study which are the Philippines
and Indonesia, include other emerging
stock markets such as Thailand, Malaysia,
68

Taiwan, South Korea, Pakistan, and India.
The monthly International Finance Corporation Global (IFCG) Price Indices that
were used for all the samples covered the
years 1990 to 1995. The price indices were
correspondingly adjusted in terms of the
U.S. dollar.
The sample firms included 30 firms
from the Philippine Stock Exchange (PSE)
and 30 firms from Jakarta Stock Exchange
(JSX), or a total of 60 firms. These firms
were selected as follows: sixty firms were
chosen from the list of firms registered
with the Philippine Stock Exchange; the
same was done for Indonesia; stock re-

Tandelilin—Gains from International Diversification and Domestic Portfolio in...

ports of the chosen firms were then examined; only firms which had transactions at
least once a month were retained; fifteen
(15) Philippine firms and ten (10) Indonesian firms were thus excluded; thirty firms
from each of the countries were then randomly selected from the remaining 45
Philippine firms and 50 Indonesian firms.
For the Philippines, the market capitaliza-

tion of these 30 firms is 25 percent of the
total while for Indonesia, the market capitalization for these 30 firms is 29 percent
of the total. This is based on the year 1995.
All the stock prices were adjusted in terms
of stock dividends, stock splits and rightissue for both the Philippine and Indonesian stocks.

Table 1. List of Samples
Philippine Stocks
1.
2.
3.
4.
5.
6.
7.
8.
9.
10.
11.
12.
13.
14.
15.
16.
17.
18.
19.
20.
21.
22.
23.
24.
25.
26.
27.
28.
29.
30.

Ayala Corporation
San Miguel Corporation
A. Soriano Corporation
Metro Pacific Corporation
Philippine Long Distance Telephone Co.
EEI Corporation
Republic Glass Holding Corporation
Bacnotan Consolidated Industries, Inc.
First Philippine Holdings Corporation
Republic Cement Corporation
Sanitary Wares Manufacturing Co.
Ayala Land Inc.
SM Development Corporation
Philex Mining Corporation
RFM Corporation
Benguet Corporation
Guoco Holding (PHILS.), Inc.
Robinson’s Land Corporation
Philippine Realty Holding
Sime Darby Pilipinas, Inc.
Dizon Copper - Silver Mines, Inc.
Jardine Davies, Inc.
Lepanto Consolidated Mining Co.
Interphil Laboratories, Inc.
Kuok Philippine Properties, Inc.
Manila Mining Corporation
House of Investment, Inc.
Trans-Asia and Mineral Dev’t. Co.
Seafront Resources Corporation
Dharmala Philippines, Inc.

Indonesian Stocks
1.
2.
3.
4.
5.
6.
7.
8.
9.
10.
11.
12.
13.
14.
15.
16.
17.
18.
19.
20.
21.
22.
23.
24.
25.
26.
27.
28.
29.
30.

P.T. Astra International
P.T. Indocement Tunggal Prakarsa
P.T. Gudang Garam
P.T. United Tractors
P.T. Bakrie Sumatra Plantations
P.T. Hero Supermarket
P.T. Roda Vivatex
P.T. Central Proteinaprima
P.T. Dharmala Agrifood
P.T. Internasional Nickel Indonesia
P.T. Petrosea
P.T. Apac Centertex Corporation
P.T. Inti Indorayon Utama
P.T. Trias Sentosa
P.T. Hanjaya Mandala Sampoerna
P.T. Supreme Cable Manufacturing Co.
P.T. Tigaraksa Satria
P.T. Gadjah Tunggal
P.T. Unilever Indonesia
P.T. Rig Tenders Indonesia
P.T. NVPD Soedarpo Corporation Corporation
P.T. Duta Anggada Realty
P.T. Astra Graphia
P.T. Great River International
P.T. Unggul Indah Corporation
P.T. Pakuwon Jati
P.T. Semen Cibinong
P.T. Summarecon Agung
P.T. Tembaga Mulia Semanan
P.T. Multipolar Indonesia

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Gadjah Mada International Journal of Business, September 1999, Vol. 1, No. 2

Methodological Procedures
There are major assumptions that
were made in the study. These assumptions apply to international and domestic
portfolio components.
1. There are no transaction costs. There is
no cost (friction) of buying or selling
any asset.
2. There are no taxes.
3. Unlimited short sales are allowed.
4. All assets are risky.
5. Investors are concerned with the mean
and variance of returns (or prices over a
single period).
A. For International Diversification
In order to examine correlation between returns of Philippine and Indonesian stocks and returns of stocks of emerging stock markets, the IFCG Total Return
Indices were used. The returns have been
calculated in dollars and, therefore, the
indices were adjusted to reflect any changes
in exchange rates during the period. As a
result, the rates of returns that were used in
this study are the relevant rates for investors in pesos or rupiah. The monthly rate of
return for each country is defined as the
percentage change in dollar value of its
index of common stocks. The following
formula was employed to calculate
monthly rate of returns:

r (rit, rjt ) =

Cov (rit, rjt )
sit, sjt

where Cov (rit, rjt) represents the covariance between stock returns of country i in
month t , and stock returns of country j in
month t; and sit, sjt represent the standard
deviation of stock returns of country i in
month t and stock returns of country j in
month t, respectively.
The potential gains from international
diversification were determined by solving for the optimal international (tangency)
portfolios to the domestic (Philippines and
Indonesia) portfolios, then comparing their
risk-return characteristics to that of the
domestic portfolios. In solving for the
optimal international portfolios, monthly
return data for national stock market indices from the period January 1990 through
December 1995 were used. Formally, the
tangency portfolio will be identified by
solving the following maximization problem (Eun and Resnick 1994):

Max q ¾
(Xi)

E(Rp) - Rf
sp
n

=

S Xi[E(Ri) - Rf]

i=1
n

n

i=1

Rit = (Pi,t - Pi,t-1)/Pi,t-1

70

i=1 j=1

N

subject to =
where Pit and Pi,t-1 represent the dollar
value of the current month t and previous
t-1 monthly country’s stock index. Rit represents the rate of return in month t -1.
The following formula was employed
to examine correlation between returns of
Philippine and Indonesian stocks and returns of stocks of emerging markets:

n

[ S Xi2si2 + S S XiXjCovij ]1/2

S X = 1.0
i=1

i

where:
Xi
= the fraction of wealth invested ith
security
E(Ri) = the expected return on the ith security
E(Rp) = the expected return on the portfolio

Tandelilin—Gains from International Diversification and Domestic Portfolio in...

Rf
rij
sp

= the risk-free interest rate
= the covariance of returns between
the ith and jth securities
= the standard deviation of returns
of the portfolio.

In order to compare the gains of diversification in emerging stock markets
for Philippine and Indonesian investors,
Sharpe Ratio was used. The following is
the formula of Sharpe Ratio:
SHP = [E(Rp) - Rf] / sp
In summary, from the data from the
IFC Global Index of the eight (8) emerging
countries, the mean, standard deviation
and correlation were computed. The next
step involved computing all possible combinations (a total of 256 combinations) of
portfolio diversification with two to eight
other Asian emerging stock markets from
the Philippine and Indonesian perspectives. Thereafter, the Sharpe Ratio, the
mean and optimum gains were derived.
For mean gain, the average of all possible
combinations were computed. On the other
hand, the optimum gain was based on the
highest Sharpe Ratio obtained from all the
possible combinations. The optimal international portfolio is that which produces
the largest gain. The last step involved
comparing the mean and optimum gains
from the Philippine and Indonesian perspectives.

B. For Domestic Portfolio
The data used in estimating the relationship between diversification and the
level of variation of portfolio returns was
computed on the 60 stocks listed in the
PSE and JSX. Observation on each stock
was taken at monthly intervals for the
period January 1991-December 1995. The
statistics employed in the calculation of

ex-post returns and the dispersion of these
returns was the geometric mean and the
standard deviation of the logarithms of the
value relatives.
To demonstrate the effect of changing the number of stocks held in a portfolio, random sample portfolios were constructed holding from two to twenty-five
securities (stocks). In order to reduce the
dependence on single samples, the exercise was repeated thirty (30) times with
different random selections. This was done
to find the optimum portfolio for stock
returns and standard deviations to be able
to compute for the Sharpe ratio.
The ex-post monthly return for period t was calculated for each stock from
the following formula, where R(k,t) is the
value relative (computed return) for security k in period t, Pk,t is the price of stock k
at the beginning of period t, P(k, t+1) is the
price of stock k at the end of period t, and
d(k,i) is the dividend paid on stock k during
period t:

Rk =

( )
P(k,i+1) + d(k,t)
P(k,t)

for t =1 to 60, and k=1 to 30
The average return over the 60 periods for each stock is given by the following, where Rk is the geometric mean return
for stock k:

(

Rk = exp (1/n)

n

S ln
t=1

)

P(k,t+1) + d(k,i)
P(k,t)

for n = 60, and k = 30
The standard deviation of the logarithms of the value relatives (the measure
of risk) for stock k over the 60 periods was
computed as follows:
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Gadjah Mada International Journal of Business, September 1999, Vol. 1, No. 2

n

S (R + R )
k,t

SDk =

2

k,t

i=1

n-1

for n = 60 and k = 30
In summary, the optimal number of
stocks in the portfolio was determined by
the following steps: first, all possible firms
from the Philippine and Indonesian stock
markets were selected; the trading records
were checked to determine whether these
non-financial firms traded at least once a
month and their financial records from
1991 to 1995 were available; second, thirty
from each of the countries were randomly
selected; third, the monthly stock prices
were adjusted in terms of stock dividends,
stock splits and right offering or issue;
stock returns were computed; random
combinations for each portfolio consisting of 2 to 25 stocks were done, for a total
of 1,440 combinations; computation of
the optimum portfolio was later done using the Investment Portfolio software (Version 1) by Elton and Gruber (1995); and
fourth, the Sharpe Ratio was computed for
the 1,440 combinations.; the ANOVA was
employed to determine the optimum number of stocks to be included in the portfolio. This was done for both the Philippine
and Indonesian stocks.

Discussion and Analysis of
Findings
This section presents a discussion
and analysis of the findings. The first part
of the section is an exploration of the gains
from international diversification in emerging stock markets (Thailand, Malaysia,
Taiwan, South Korea, Pakistan, and India)

72

from the Philippine and Indonesian perspectives. In the second part, the rate of
the variation of the returns for randomly
selected stocks to form domestic portfolios is examined. Alongside this, the discussion will also focus on the tests to
determine the number of securities that
may be included to obtain an optimal investment portfolio for Philippine and Indonesian investors.

On International Diversification
Bailey and Stulz (1990), Solnik
(1995), Madura and Soenen (1992) extensively discussed the benefits of international diversification. They concluded from
their analysis that benefits are substantial
in international diversification. Earlier,
Errunza (1988) provided further evidence
on the benefits of portfolio investments in
emerging markets. The data in the current
study support the contention of Bailey and
Stulz, as well as Errunza’s, that there are
gains in international diversification. Moreover, the positive percentage gains as reflected in the differences between international diversification and domestic portfolio in terms of Sharpe ratio (SHP) indicate
that there are benefits that can be derived
from diversifying internationally. The data
analysis involved diversifying investment
in two to eight countries taken from the
Philippine and Indonesian perspectives.
To determine if there are gains in
international diversification from the Philippine and Indonesian perspectives, the
emerging stock markets were combined in
combinations consisting of two to eight
markets. Subsequently, the average mean
SHPs and percentage gains were computed. Table 2 presents the results of all the
possible combinations and their corresponding Mean SHPs and percentage
gains.

Tandelilin—Gains from International Diversification and Domestic Portfolio in...

Table 2. Comparison Between Philippine and Indonesian Perspectives in Terms of
Percentage Gains of Mean SHP
Philippine Perspective

Indonesian Perspective

(Domestic SHP = 0.1176)

(Domestic SHP = 0.0769)

Mean SHP*

Gains (%)**

Mean SHP*

Gains (%)**

2 Countries

0.1463

24.38

0.1302

69.35

3 Countries

0.1730

47.15

0.1607

109.03

4 Countries

0.1910

62.43

0.1877

144.11

5 Countries

0.2061

75.22

0.2050

166.55

6 Countries

0.2186

85.92

0.2187

184.42

7 Countries

0.2319

97.16

0.2307

199.97

8 Countries

0.2405

104.51

0.2405

212.74

Portfolio of:

*

Mean SHP is the average mean for each combination

** Percentage gains is computed by deducting the Mean SHP from the Domestic SHP over
Domestic SHP multiply by 100 (e.g. in 8 countries for the Philippine perspective, (0.24050.1176) / 0.1176 x 100 = 104.51). Rf = 0.

Table 3. Comparison Between Philippine and Indonesian Perspectives in Terms of
Percentage Gain of Optimum Combination SHP
Philippine Perspective

Indonesian Perspective

(Domestic SHP = 0.1176)

(Domestic SHP = 0.0769)

Optimal
SHP*

Gains (%)**

Optimal
SHP*

Gains (%)**

2 Countries

0.1932

64.27

0.2000

160.08

3 Countries

0.2152

82.98

0.2169

182.01

4 Countries

0.2273

93.26

0.2333

203.42

5 Countries

0.2326

97.75

0.2375

208.84

6 Countries

0.2368

101.40

0.2375

208.84

7 Countries

0.2400

104.08

0.2375

208.84

8 Countries

0.2405

104.51

0.2405

212.74

Portfolio of:

*

Optimum SHP refers to the highest SHP from all possible combinations for two up to eight
countries.
Refer to Appendix B for details.
** Percentage gains is computed by deducting Optimum SHP from Domestic SHP/over Domestic
SHP multiply by 100.
73

Gadjah Mada International Journal of Business, September 1999, Vol. 1, No. 2

Table 2 indicates that for both the
Philippine and Indonesian perspectives,
there are gains from diversifying in the
different emerging stock markets. It can
be noted that on the basis of Mean SHP,
the Philippines appears to be higher than
Indonesia in most combinations, except
for the 6-country combination. However,
taking into account their respective domestic SHPs, the resulting percentage gains
indicate that Indonesia seems to be higher
than the Philippines.
From all the possible country combinations, the highest Sharpe ratio was chosen. The countries that have the highest
SHP constitute the optimum portfolio diversification from two to eight possible
country combinations. Table 3 presents
the optimum SHPs and the corresponding
percentage gains from the Philippine and
Indonesian perspectives.
With respect to optimum SHPs, there
seem to be a mix of results. From the
Indonesian perspective, it is higher, compared to the Philippine perspective, for 2,
3, 4, 5 and 6 country combinations. On the
other hand, the Philippine perspective is
higher in 7 country combinations. However, the Indonesian perspective is higher
than the Philippine perspective in all country combinations in terms of percentage
gains. The following figure further shows
the comparative results in terms of optimum SHPs from the Philippine and Indonesian perspectives.
The results generally indicate that
gains from international diversification can
be derived from either investing in the
countries that have low correlation in their
respective stock returns or the countries
that have high stock returns. Moreover,
the results further imply that for standard
deviation to be reduced, countries that
have the lowest correlation may be chosen. On the other hand, if gains from
74

international diversification in terms of
high returns are the primary consideration,
the countries with high returns may be
chosen. The gains therefore of international diversification can be derived from
investing in countries with high stock returns or those with lower standard deviations. According to Bailey and Stulz
(1992), the extent to which the variance
can be reduced depends on the variance of
the foreign indices, on their correlation
with the home country (in this case, the
Philippines and Indonesia) and other foreign countries (the emerging stock markets), and on their mean returns.
One aspect of the study that is significant is the relationship between volatility
and correlation. Iben and Litterman in
their study of 1994 asked whether return
correlation in general increase with the
level of market volatility. Their findings
show mixed results. From a U.S. investor’s
perspective, there is no systematic positive relationship between the level of volatility and correlation. However, from the
perspective of Germany and Japan, there
seems to be a positive relationship between levels of volatility and correlation.
Additionally, their study found that while
volatility has increased markedly for international investors, diversification benefits have remained relatively stable. In
the current study, it is interesting to note
that while the volatility (standard deviations) of the Philippine stocks is higher
than the Indonesian stocks, the correlation
are almost the same. This finding supports
the U.S. experience.
Furthermore, from the Indonesian
perspective, the gain from international
diversification is from high returns and
low standard deviation in combinations up
to four countries. However, for the five- to
eight- country combinations, the gain is
from high returns and not from low stan-

Tandelilin—Gains from International Diversification and Domestic Portfolio in...

Figure 2. Comparative Results Between The Philippine and Indonesian Stocks in
Terms of Mean and Standard Deviations
0.0900

Meand and Standard Deviation

0.0800
0.0700
0.0600
0.0500
0.0400
0.0300
0.0200

12
12 12
12
12 12
12
12
0.0000 12

0.0100

1

12
12123
12
123
12123
123
12
123
12123

12
12 123
123
12
12 123
123
123
12
12 123
123
12 123

2

3

12
123
12123
123
12
12123
123
123
12
12123
123
12123

12
12
12
12 12
12
12
12 12
12
12
12
12 12
12
12 12

4
5
Number of Countries

12
12
12
12
12 12
12 12
12
12
12
12 12
12
12
12
12 12

12
12
12 12
12
12
12
12 12
12
12
12
12 12
12
12
12
12 12

12
12
12 12
12
12
12
12 12
12
12
12
12 12
12
12
12
12 12

6

7

8

12
12 Ph-ME
Ph-SD

123
123 Ind-ME

12
12Ph-ME

Figure 3. Trends of the Philippine Peso and the Indonesian Rupiah (In Relation to
the U.S. Dollar Rate) From 1991-1995
30

Pesos-Rupiah (00)/U.S.$

25

20

15

10

5

0
1991

1992

1993

YEAR

1994

1995
PHILIPPINES
INDONESIA (00)

75

Gadjah Mada International Journal of Business, September 1999, Vol. 1, No. 2

dard deviation. However, both Indonesia
and the Philippines gained from international diversification as can be seen in
Table 2 and Table 3.
In comparison, however, the gain
based on SHP is higher from the Indonesian perspective than from the Philippine
perspective. One reason could be that Indonesia has a lower mean return and SHP
than the Philippines. It is therefore much
easier to achieve greater gains from the
Indonesian perspective (Figure 2).
Another reason could be the differences in exchange rate (all the computations are in terms of dollar returns; proper
adjustments to the dollar were made). For
the selected time period, the Philippine
peso remained relatively stable and less
depreciated as compared to the Indonesian
rupiah which constantly depreciated visa-vis the dollar. Figure 3 shows the trends
of the Philippine peso and the Indonesian
rupiah in relation to the dollar from 1991
to 1995.
The current study did not include
directly the significant impact of foreign
exchange risk as a variable in international
diversification. However, many studies
have indicated that foreign exchange hedging plays an important role in international
investment decisions. Filatov and
Rappoport (1992), for instance, indicated
that if covariance between exchange rate
and stock returns are zero or positive it will
be optimal to be fully or even over-hedged.
It means that currency exposure contributes to diversification if depreciation of
the domestic currency tends to be accompanied by lower-than-average foreign and
domestic returns, denominated in their
local currencies. Eun and Resnick (1994)
tried to integrate foreign currency as an
important component of foreign investment risk between U.S. and Japanese investors. They found that hedging exchange
76

risk is found to generally increase the
benefits from international investment but
only for the U.S. investor. The finding was
based on the depreciation of the yen vis-avis the dollar. As a whole, while it is true
that foreign currency hedging is an important variable in international diversification, Odier and Solnik (1993) implied that,
unfortunately, there is no formula for determining whether or not to hedge currency risk or even how much of it to hedge.
They added that the difficulty of arriving
at an optimal currency-hedging policy in
part reflects the lack of an observable,
universally efficient portfolio for international stocks and equity.

On Domestic Diversification
This section focuses on the domestic
portfolio and presents the gains from relative returns and standard deviations (variations), or Sharpe Ratio (SHP), for randomly selected portfolios for the Philippines and Indonesia. Included here is a
presentation of the results which show the
increase of Sharpe ratio (SHP) as a function of the number of stocks included in
the portfolio.
In the analysis of the Philippine experience, the gains in terms of Sharpe ratio
were registered in portfolios with up to
fourteen (14) stocks. This simply means
that increase of Sharpe ratio can only be
obtained with up to fourteen stocks in the
portfolio; beyond fourteen, there is no
difference. This is shown by the ANOVA
analysis (Figure 4).
Table 4 further shows analysis to
support the multiple range tests. It aims to
present a validation of the above results.
Therefore, for the Philippines, fourteen (14) is the optimal number of stocks
to derive gains in terms Sharpe ratio (SHP).
On the other hand, the Indonesian experience shows a higher number at 15.

Tandelilin—Gains from International Diversification and Domestic Portfolio in...

Figure 4. Results of ANOVA for Optimum Number of Stocks in the Portfolio for
Philippine Stocks
Multiple Range Tests: Modified LSD (Bonferroni) Test
with significance level .05
GGGGGGGGGGGGGGGGGGGGGGGG
r r r r r r r r r r r r r r r r r r r r r r r r
p p p p p p p p p p p p p p p p p p p p p p p p
1 1 1 1 1 1 1 1 2 1 1 2 2 2 2 2
2 3 4 5 6 7 8 9 0 1 2 3 4 5 6 8 0 9 7 3 5 2 1 4
Mean

STOCKS

.1297
.1687
.1956
.2183
.2280
.2325
.2476
.2631
.2780
.2813
.2992
.3009
.3206
.3342
.3494
.3506
.3512
.3523
.3529
.3565
.3571
.3576
.3580
.3582

Grp 2
Grp 3
Grp 4
Grp 5
Grp 6
Grp 7
Grp 8
Grp 9
Grp10
Grp11
Grp12
Grp13
Grp14
Grp15
Grp16
Grp18
Grp20
Grp19
Grp17
Grp23
Grp25
Grp22
Grp21
Grp24

*
* *
* *
* *
* * *
* * *
* * * * *
* * * * * *
* * * * * * *
* * * * * * *
* * * * * * * *
▼
* * * * * * * * * *
* * * * * * * * * * * *
* * * * * * * * * * * *
* * * * * * * * * * * *
* * * * * * * * * * * *
* * * * * * * * * * * *
* * * * * * * * * * * *
* * * * * * * * * * * *
* * * * * * * * * * * *
* * * * * * * * * * * *
* * * * * * * * * * * *

The difference between two means is significant if MEAN(J)-MEAN(I) • .0344 *
RANGE * SQRT(1/N(I) + 1/N(J)) with the following value(s) for RANGE: 5.32
(*) Indicates significant differences which are shown in the lower triangle.

77

Gadjah Mada International Journal of Business, September 1999, Vol. 1, No. 2

Table 4. Summary of ANOVA for 5 Groups of Portfolio Combination of Philippine
Stocks.
Analysis of Variance
(2 Stocks - 5 Stocks)
Source

D.F.

Sum of
Squares

Mean
Squares

F
Ratio

F
Prob.

Between Groups
Within Groups
Total

3
116
119

.1306
.2449
.3755

.0435
.0021

20.6204

.0000 *

(6 Stocks - 10 Stocks)
Source

D.F.

Sum of
Squares

Mean
Squares

F
Ratio

F
Prob.

Between Groups
Within Groups
Total

4
145
149

.0525
.2812
.3337

.0131
.0019

6.7634

.0001 *

(11 Stocks - 15 Stocks)
Source

D.F.

Sum of
Squares

Mean
Squares

F
Ratio

F
Prob.

Between Groups
Within Groups
Total

4
145
149

.0504
.3780
.4284

.0126
.0026

4.8379

.0011 *

(16 Stocks - 20 Stocks)
Source

D.F.

Sum of
Squares

Mean
Squares

F
Ratio

F
Prob.

Between Groups
Within Groups
Total

4
145
149

.0002
.3877
.3879

.0001
.0027

.0213

.9991

(21 Stocks - 25 Stocks)
Source

D.F.

Sum of
Squares

Mean
Squares

F
Ratio

F
Prob.

Between Groups
Within Groups
Total

4
145
149

.0001
.3538
.3538

.0000
.0024

.0057

.9999

(*) Multiple Range Tests: Modified LSD (Bonferroni) test with significance level .05
78

Tandelilin—Gains from International Diversification and Domestic Portfolio in...

Figure 5. Results of ANOVA for Optimum Number of Stocks in the Portfolio for
Indonesian Stocks
Multiple Range Tests: Modified LSD (Bonferroni) Test
with significance level .05
GGGGGGGGGGGGGGGGGGGGGGGG
r r r r r r r r r r r r r r r r r r r r r r r r
p p p p p p p p p p p p p p p p p p p p p p p p
1 1 1 1 1 1 1 1 1 1 2 2 2 2 2 2
2 3 4 5 6 7 8 9 0 1 2 3 4 5 6 7 8 9 1 2 5 4 0 3
Mean

STOCKS

.0831
.1290
.1625
.1867
.2084
.2217
.2405
.2630
.2843
.3070
.3234
.3400
.3627
.3886
.4026
.4328
.4529
.4718
.4769
.4791
.4809
.4823
.4831
.4833

Grp 2
Grp 3
Grp 4
Grp 5
Grp 6
Grp 7
Grp 8
Grp 9
Grp10
Grp11
Grp12
Grp13
Grp14
Grp15
Grp16
Grp17
Grp18
Grp19
Grp21
Grp22
Grp25
Grp24
Grp20
Grp23

*
*
*
* *
* * *
* * * *
* * * * *
* * * * * *
* * * * * * *
* * * * * * * *
* * * * * * * * *
* * * * * * * * *
* * * * * * * * * * * ▼
* * * * * * * * * * * * *
* * * * * * * * * * * * *
* * * * * * * * * * * * *
* * * * * * * * * * * * *
* * * * * * * * * * * * *
* * * * * * * * * * * * *
* * * * * * * * * * * * *
* * * * * * * * * * * * *

The difference between two means is significant if MEAN(J)-MEAN(I) • .0702 *
RANGE * SQRT(1/N(I) + 1/N(J)) with the following value(s) for RANGE: 5.32
(*) Indicates significant differences which are shown in the lower triangle.

79

Gadjah Mada International Journal of Business, September 1999, Vol. 1, No. 2

Table 6. Summary of ANOVA for 5 Groups of Portfolio Combination of Indonesian
Stocks.
Analysis of Variance
(2 Stocks - 5 Stocks)
Source

D.F.

Sum of
Squares

Mean
Squares

F
Ratio

F
Prob.

Between Groups
Within Groups
Total

3
116
119

.1811
.6653
.8465

.0604
.0057

10.5266

.0000 *

(6 Stocks - 10 Stocks)
Source

D.F.

Sum of
Squares

Mean
Squares

F
Ratio

F
Prob.

Between Groups
Within Groups
Total

4
145
149

.1127
1.4680
1.5807

.0282
.0101

2.7829

.0289 *

(11 Stocks - 15 Stocks)
Source

D.F.

Sum of
Squares

Mean
Squares

F
Ratio

F
Prob.

Between Groups
Within Groups
Total

4
145
149

.1243
1.3815
1.5058

.0311
.0095

3.2609

.0135 *

(16 Stocks - 20 Stocks)
Source

D.F.

Sum of
Squares

Mean
Squares

F
Ratio

F
Prob.

Between Groups
Within Groups
Total

4
145
149

.1235
1.4287
1.5521

.0309
.0099

3.1326

.0166 *

(21 Stocks - 25 Stocks)
Source

D.F.

Sum of
Squares

Mean
Squares

F
Ratio

F
Prob.

Between Groups
Within Groups
Total

4
145
149

.0008
1.9256
1.9264

.0002
.0133

.0148

.9996

(*) Multiple Range Tests: Modified LSD (Bonferroni) test with significance level .05
80

Tandelilin—Gains from International Diversification and Domestic Portfolio in...

In contrast with the Philippines’ 14
stocks, the test reveals that no significant
difference in SHP is obtained beyond 15
for Indonesia. This simply indicates that to
form the optimal portfolio, an investor in
Indonesia can invest in 15 stocks. This is
reflected in Figure 5.
Further analysis (Table 6), however,
indicate significant difference between
holding 16 and 20 stocks. This is because
of the high Sharpe Ratios (SHP) obtained
from group 20, which may be peculiar to
the particular sample obtained. Practical
considerations, however, would indicate
that 15 stocks be maintained in the Indonesia portfolio.
The difference may be attributed to
the higher intercorrelation among the
Philippine stocks. This implies that systematic risk may be higher in the Philippines than in Indonesia. According to
Solnik (1995), as diversification increases,
the risk of portfolio decreases but not
proportionately. He added that very quickly
the marginal reduction in variability of
adding an extra security in the portfolio
becomes smaller. In this study, the marginal increase of Sharpe ratio was used.
Moreover, Peavy and Rauscher
(1994) stated that domestic diversification
benefits accrue only for portfolios containing combination of stocks with varying levels of correlation. He added that a
portfolio consisting of 20 stocks in different industries provide substantial diversification benefits as a result of the low
cross-correlation coefficients (inter-correlation) among the individual securities.
On the other hand, a portfolio comprised
of 20 large oil companies achieves virtually no diversification benefits because
the component securities are highly correlated. This contention may apply in the

Philippine setting as there is a lower optimal number of stocks to form an investment portfolio as compared to Indonesia.
Franco Modigliani and Gerald Prague
(as cited by Peavy and Rauscsher 1994)
explained how most of the possible diversification benefits occur in a portfolio
containing as few as 10 stocks in different
industries. A 20-stock diverse portfolio
derives virtually all possible diversification benefits within an asset class.
In terms of correlation, the Philippines’ stocks have more significant intercorrelation as compared to the Indonesian
stocks. As stated earlier, this explains the
lesser number of stocks that form the portfolio of domestic investment from the
Philippine perspective as compared to the
Indonesian situation.
The findings of the current study provide some support to the contention of
Sharpe (1995) on the significance of diversification in constructing a portfolio.
He stated that “the more securities in a
portfolio, the greater the likelihood that
sufficient good fortune will appear to balance off the bad fortune.” He added that
the number of securities in a portfolio
provides a fairly crude measure of diversification and that more non-market risks
should be considered. Greater correlation
is observed among the Philippine stocks
which implies there is more systematic
risk. The result is less effective diversification in terms of the number of securities
for the Philippines (14) as compared to
Indonesia (15). From this, it can be seen
that Sharpe’s viewpoint is supported by
the Indonesian case, that is, the higher the
non-market or unsystematic risk, the more
effective the diversification on the basis of
the number of securities in a portfolio.

81

Gadjah Mada International Journal of Business, September 1999, Vol. 1, No. 2

Conclusion
The study is generally focused on the
benefits of portfolio diversification. Previous studies have shown that international diversification is now well accepted
as a beneficial portfolio management alternative. The Asian Pacific stock markets
have been cited as alternative financial
interests for international diversification
strategies because of their significant developments.
The study was organized into two
major concerns. First, the study aimed at
finding the gains from international diversification in emerging stock markets (Thailand, Malaysia, Taiwan, South Korea, Pakistan, and India) from the Philippine and
the Indonesian perspectives and to determine which perspective yields the greater
gains. Second, the study determined how
many securities must be included to obtain
an optimal investment portfolio from the
Philippine and Indonesian perspectives.
The monthly International Finance
Corporation (IFC) Price Indices, covering
the years 1990 to 1995, were used for all
the emerging stock market samples. To
compare the Philippine Stock Exchange
(PSE) and the Indonesian Stock Exchange
(JSX), 30 listed companies from PSE and
30 listed companies from JSX respectively were matched and randomly selected, for a total number of 60 non-financial firms. Monthly stock returns used for
all the samples covered the years 19911995.
The findings were: First, there are
gains from international diversification
both from the Philippine and Indonesian
perspectives in two to eight emerging stock
markets. Generally, the gains are greater
from the Indonesian perspective than the
Philippine perspective in all country combinations. However, in terms of Mean

82

SHP (International Portfolio), the Philippines is higher than Indonesia in almost all
possible country combinations (except 6
countries). Indonesia is higher in terms of
percentage gains of Mean SHP in all country combinations. In terms of optimum
SHPs, results are mixed. From the Indonesian perspective, it is higher for 2, 3, 4, 5
and 6-country combinations. On the other
hand, optimum SHP is higher in 7-country
combinations from the Philippine perspective. The Indonesian perspective yielded
higher percentage gains of optimum SHP
in all country combinations. Second, the
tests show that fourteen (14) stocks comprise the optimum investment portfolio
for the Philippines while fifteen (15) comprise that of Indonesia.
A superior investment strategy is one
that can identify and reduce risks that bear
on compensation. The reduction can be
accomplished simply and effectively by
means of diversification. Diversification
is the most important concept in portfolio
risk management. Improved diversification can produce higher returns at lower
risk. The evidence presented in the study
has important implications for the significance of portfolio diversification. Results
of the study provide evidence that there are
substantial benefits that can be gained
through portfolio diversification in emerging stock markets from the Philippine and
Indonesian perspectives. The results could
be viewed largely as being indicative rather
than conclusive because other variables
such as currency and political risks were
not integrated in the data analysis. As a
whole, nonetheless, the benefits from international diversification are so large that
foreign investors will be encouraged to
place their money in these emerging markets. Eventually, this will rapidly resuscitate and further develop financial markets

Tandelilin—Gains from International Diversification and Domestic Portfolio in...

in the emerging stock markets in Asia,
specifically in the Philippines and Indonesia.
The study reveals that there is a certain maximum limit for optimal domestic

diversification. Moreover, the number of
stocks to form an optimum investment
portfolio differs for the Philippine and
Indonesian perspectives.

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Tandelilin—Gains from International Diversification and Domestic Portfolio in...

Dr. Eduardus Tandelilin is Associate Professor of Finance and
Executive Director of Quality for Undergraduate Education (QUE) Project
at Faculty of Economics, Gadjah Mada University.

85