Surprising New Research on Diversification from Emerging Markets
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A list of Dan Richards previous articles appears at the end of this article.
Historically there have been two reasons to invest in emerging markets such as China, India and Brazil.
The first is the promise of higher returns that come with faster growing economies, albeit with greater volatility.
And the second is the prospect that emerging markets will offer diversification from the performance of stocks in developed economies: the U.S., Europe and Japan.
New research into the impact of global diversification, though, has produced some surprising results.
The fundamental principle underlying diversification
Diversification is one of the time-honored tenets of sound investing the dont put all your eggs in one basket notion that spreading investments across countries and regions will reduce risk.
Faith in diversification was one of the many casualties of the financial meltdown, as even the most diversified stock portfolios took a big hit.
On March 16, four McGill University academics released a study titled Is the potential for international diversification disappearing?
Written by Peter Christoffersen, Vihang Errunza, Kris Jacobs and Xisong Jin, this paper has caused a stir its been among the top 10 downloaded papers on the SSRN site where economists and other academics post papers.
The authors set out to examine the degree to which different stock markets operate in tandem to the extent that stock markets move in lock step, downside protection in declining markets is minimal.
Diversification in developed markets
The authors first looked at 16 developed markets in North America, Europe and Japan going back to 1973. All of the major advanced economies were included in their sample.
Assigning each of these markets equal weight (so that Denmark was as important as the United States), they looked at the extent to which stock price movements among developed market were correlated - with 0 meaning there was absolutely no correlation at all between markets, 1 meaning they were entirely correlated. The higher the correlation, the less the benefit of diversification.
What the authors found was that since the early 1990s, there has been a steady upward climb in correlation of stock movements among developed countries with a resulting reduction in the diversification benefits of investing across advanced economies. This climb in correlation has especially accelerated since 2000.
Peter Christoffersen, one of the study co-authors, told me: Theres been a lot of movement up and down along the way. But if you strip out the noise, correlations between developed markets have nearly doubled from 0.4 in the early 1990s to 0.8 today. There are a number of possible reasons for this one might be the integration of European economies as a result of the Euro, another might be the continued push towards a globalized world.
What that means is today diversification benefits to investing across developed economies have been reduced. That doesnt mean there cant be good investment opportunities in other developed markets but these decisions should be made on their investment merits, not to diversify risk away.
Diversification within emerging markets
The authors then went on to look at emerging markets.
Leading up to the financial crisis, there was lots of talk about global decoupling the notion that economies like China and India had reached the point that their markets would perform independently of the US, Europe and Japan.
The authors set out to examine this hypothesis. They first looked at 13 markets for which there is good market data going back to 1989 and another five for which good quality data became available in 1995. In the first group were countries like Brazil, India, Korea, Taiwan and Turkey; correlation within those emerging market started at 0.2 in 1989 and reached 0.5 in the height of the financial crisis since then correlation has dropped back to about 0.3.
In 1995, a different source of data became available that included China, Indonesia, Hungary, Indonesia and Peru, although Columbia was dropped due to data problems. Using the new data set, the correlation among all 17 emerging markets has moved up to around 0.6.