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Persistent Usefulness of Emerging Markets in Equity Diversification

| | Posted in: Equity Premium, Strategic Allocation

How does consideration of return distribution tails (not just linear correlations) affect assessment of global equity diversification benefits? In their May 2012 paper entitled “Is the Potential for International Diversification Disappearing? A Dynamic Copula Approach”, Peter Christoffersen, Vihang Errunza, Kris Jacobs and Hugues Langlois examine the evolution of equity market diversification benefits based on a methodology that accommodates non-linearity in the relationship between return streams. They focus on differences between developed and emerging markets. Using weekly returns in U.S. dollar for 16 developed markets during January 1973 through mid-June 2009, 13 emerging markets during late January 1989 through July 2008 and 17 emerging markets during July 1995 through mid-June 2009, they find that:

  • During late January 1989 through July 2008, the average annualized return in developed (emerging) markets is 12.1% (17.7%), with annual standard deviation 18.4% (33.6%). Skewness is slightly negative (positive) in developed (emerging) markets. Kurtosis is on average higher in emerging markets (more tail risk).
  • Interdependence trends upward for both developed and emerging markets over the sample period, but that among developed markets is consistently higher than that among emerging markets. On a regional basis (EU, developed non-EU, Latin America and Emerging Eurasia), average interdependence across and within regions also trends upward.
  • Return distribution tail effects are important and increasing contributors to market interdependence for both developed and emerging markets, with the left-tail (crash) contribution higher than the right-tail contribution. However, at the end of the sample period, tail contributions for emerging markets are very low compared to those for developed markets, apparently because financial crises in emerging markets tend to be country-specific.
  • Diversification benefits of emerging markets, while decreasing over the past decade, remain significant at the end of the sample period.

In summary, evidence from tests that consider tail effects in diversification benefits indicate that emerging markets retain considerable value in diversifying equity portfolios.

Cautions regarding findings include:

  • The interdependence measurement methodology is complex.
  • Analyses are for equities only.
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