International portfolio allocation with European fixed-income funds: What scope for Italian funds?

We study optimal asset allocation for a portfolio of European fixed-income mutual funds during the recent financial turmoil. We use a sample of daily returns for country indices of French, German and Italian funds to investigate the quest for international diversification. Our analysis focuses on the specific role of Italian funds. We compute optimal portfolio allocations from a modified mean-variance framework that takes as input the out-of-sample forecasts for the conditional mean, volatility and correlation of the funds returns. VaR forecast comparisons between alternative models provide support for a fractionally-integrated GARCH for the conditional variance. The interaction between the funds is modelled as the Dynamic Conditional Correlation of Engle (2002). Our results are twofold. First, the optimal portfolio allocates more than 50% of assets to German funds, while assigning equal shares of approximately 20% to both French and Italian funds. This strategy generates portfolio returns that are more stable than those of our competing models. It is also characterized by a worsening of the risk-return tradeoff throughout the evaluation period. The second result is that overweighing Italian funds with respect to the optimal strategy causes the portfolio to hold additional volatility of returns without generating compensation for risk.