Allocating emerging market equity in a diversified portfolio : an evaluation

Abstract

This quantitative study aims to understand the benefits available to investors who expose their dollar denominated equity portfolios to emerging markets (EM). This research explored and analysed the effects of the changes in the US monetary policy environment (i.e. increase or decrease in interest rates) on the equity performance in EMs. The researcher aimed to highlight the diversification benefits that exposures in these markets give investors through lower correlation with developed equity market performance. This study analysed monthly return data of nine of the largest EM economies together with three developed market composite indexes and one EM composite index over a span of nineteen years. Following the analysis of the full set of data, the data was divided into two samples; periods of expansive and restrictive monetary policy environments. Furthermore, an efficient portfolio analysis was undertaken in order to analyse the benefits of these markets within a portfolio. The results obtained showed that the individual EM indexes, during periods of restrictive US monetary policy obtained higher returns with lower volatility when compared to expansive monetary policy periods. The benefits of EMs were further analysed through an efficient portfolio analysis which indicated that exposing portfolios to EMs during periods of expansive monetary policy provided more diversification benefits to investors. The results obtained indicate that the inclusion of EM equity in a diversified equity portfolio throughout spells of expansive monetary policy, can serve to hedge the poor performance of the developed market indexes and act as a better portfolio diversifier. That being said, exposure towards the MSCI EM index in both periods proved to benefit investors by expanding the set of mean-variance efficient portfolios that they were able to achieve at different levels of risk.