Surprising New Research on Diversification from Emerging Markets
March 30, 2010
by Dan Richards
Mixing emerging and developed markets
The most interesting question is what happens to correlations when you add emerging markets to developed markets.
Another of the authors, Vihang Errunza, has been researching emerging markets since 1972 and in the 1980s played a lead role in developing the World Banks emerging markets database.
We discussed the trend in correlations, based on the five years to June of last year. His conclusions:
For those five years, within 17 emerging markets, correlations averaged about 0.5
Among 16 developed markets, correlations averaged roughly 0.7.
And adding all 33 markets together, correlations averaged around 0.6, slightly reducing correlations of investing in developing markets alone.
This doesnt entirely debunk the decoupling hypothesis, there were some diversification benefits to emerging markets but they were limited.
Its important to remember that this study assumes equal importance to all markets a practice that no one would recommend.
Nonetheless, the authors key conclusion is that unlike developed markets, there appear to be some diversification benefits to adding emerging markets to a portfolio, although these are shrinking over time.
Diversification in extreme periods
The final and most important question the study authors examined is the correlation of emerging and developed markets during periods of extreme market events, the chances of two markets going crazy at the same time as Peter Christoffersen put it when investors need diversification the most.
Here the news was more positive over the past five years adding emerging markets has significantly reduced the negative impact when extreme events happen simultaneously.
When I asked the authors to run the correlation data for the fourth quarter of 2008, the year of the financial crisis, heres what correlations looked like:
Within 16 developed markets: .71
Within 17 emerging markets: .50
Within all 33 markets: .57
Historically, many of the fundamental tenets that guided investors were a matter of faith.
Increasingly its possible to look at some of these beliefs under the microscope of hard data - some stand up to scrutiny, others dont.
When it comes to the benefits of geographic diversification in reducing stock risk, the message is clear.
First, diversification across developed markets offers little or no risk reduction.
Diversification across developed and emerging markets offers more risk reduction, although that appears to have been shrinking as well. As a result, investors will increasingly have to look for strategies beyond geographic diversification to reduce risk in their portfolios.
Offsetting that, for at least the five years to last June, the data indicate that during market crises when investors need diversification the most, the case for emerging markets remains strong. And thats perhaps the most powerful argument for emerging markets of all.
* Dan Richards conducts programs to help advisors gain and retain clients and is an award winning faculty member in the MBA program at the University of Toronto. To see more of his written and video commentaries and to reach him, go to www.clientinsights.ca.