STRATEGIC ASSET ALLOCATION IN A SMALL OPEN ECONOMY: EVIDENCE FROM ICELAND, 1992–2024

Abstract

This paper examines the long-term strategic asset allocation of investors in small open economies, where the domestic financial markets are limited, unstable and vulnerable to significant country-specific shocks. Iceland is used as a case study. All wealth, risk and portfolio outcomes are evaluated in Icelandic krona (ISK). The analysis covers the period from 1992 to 2024, including financial liberalisation, the 2008 banking collapse, years of capital controls, and the subsequent tourism-led recovery. The study considers the following eight asset classes, which are available to Icelandic investors and constitute a realistic investable universe: These are Icelandic government bonds; a short-term, risk-free ISK asset; Icelandic equities; global, developed-market equities (MSCI World); emerging-market equities (MSCI Emerging Markets); US Treasury bills; UK government bonds; and gold. As foreign assets are held unhedged, returns reflect both asset-price movements and exchange-rate changes. Using annual data, the paper first documents the long-term risk and return characteristics of each asset in ISK terms. This includes arithmetic and geometric mean returns, volatility, correlations and behaviour during periods of crisis. It then applies a standard long-only mean–variance framework to characterise efficient portfolios for an ISK-based investor with a long time horizon. The results show that, despite high average one-year returns, domestic equities perform poorly in the long run. The collapse of 2008, in particular, drives their real geometric mean return below zero over the full sample due to extreme downside risk. In contrast, global equities deliver the strongest and most stable long-term growth in ISK, achieving the highest risk-adjusted performance. Foreign safe assets and gold offer robust protection during years of severe currency depreciation, but their average excess returns are insufficient for them to play a pivotal role in long-term efficient portfolios. Consequently, the efficient frontier is reduced to a combination of domestic government bonds, the risk-free ISK asset and global equities, with domestic equities and other foreign assets being largely excluded. The findings emphasise the significant expense of home bias in small, open economies with independent currencies. In the long term, achieving portfolio efficiency requires meaningful exposure to global equity markets, anchored by high-quality domestic bonds rather than heavy reliance on domestic equities.