International portfolio diversification and multilateral effects of correlations

Not only are investors biased toward home assets, but when they do invest abroad, they appear to favor countries with returns more correlated with home assets. Often attributed to a preference for familiarity, this 'correlation puzzle' further reduces effective diversification. We use a multi-country general equilibrium model of portfolio choice to study how bilateral equity holdings are affected by return correlations among alternative destination and source countries. From the theoretical model, we develop an empirical approach to estimate a gravity equation for equity holdings that incorporates the overall covariance structure in a theoretically rigorous yet tractable manner. Estimation using this approach resolves the correlation puzzle, and finds that international investors do seek the diversification benefits of low cross-country correlations, as theory would predict. (C) 2015 Elsevier Ltd. All rights reserved.