The diversification potential offered by emerging markets in recent years

Abstract

This paper investigates the diversification prospects which may be reaped when investing in a mixture of emerging and developed market assets. Given that emerging markets are somewhat distinct from developed ones, one may expect significant diversification potential and therefore risk reduction. Yet, the latter may be counterbalanced by the fact that emerging markets usually present higher risks when considered on their own; for instance higher price volatility and fluctuating liquidity.

We use a panel data set spanning over a 10 year period and form a number of portfolios. We find that over the sample period, emerging market assets could be combined into efficient portfolios when assessed in terms of risk and return. By contrast, portfolios involving developed market assets tended to be inefficient.

We also investigate whether emerging markets have converged to developed ones over the past years. When analysing co-movements between indices, the correlation values suggest that emerging markets have offered diversification potential. However we also find evidence of features which make it more challenging to reap the expected risk reduction benefits. The latter factors are the tendency for emerging markets to exhibit a higher individual variability, and the trend for markets to move more in line with each other as suggested by convergence literature.