International diversification for portfolios of European fixed-income mutual funds: The case of core EMU countries

Purpose: The purpose of this paper is to study the scope for country diversification in international portfolios of mutual funds for the “core” EMU countries. The author uses a sample of daily returns for country indices of French, German and Italian funds to investigate the quest for international diversification. The author focuses on fixed-income mutual funds during the period of the financial market turmoil since 2007. Design/methodology/approach: The author compute optimal portfolio allocations from both unconstrained and constrained mean-variance frameworks that take as input the out-of-sample forecasts for the conditional mean, volatility and correlation of country-level indices for funds returns. The author also applies a portfolio allocation model based on utility maximization with learning about the time-varying conditional moments. The author compares the out-of-sample forecasting performance of 12 multivariate volatility models. Findings: The author finds that there is a “core” EMU country also for the mutual fund industry: optimal portfolios allocate the largest portfolio weight to German funds, with Italian funds assigned a lower weight in comparison to French funds. This result is remarkably robust across competing forecasting models and optimal allocation strategies. It is also consistent with the findings from a utility-maximization model that incorporates learning about time-varying conditional moments. Originality/value: This is the first study on optimal country-level diversification for a mutual fund investor focused on European countries in the fixed-income space for the turmoil period. The author uses a large array of econometric models that captures the salient features of a period characterized by large changes in volatility and correlation, and compare the performance of different optimal asset allocation models.