The Best of Both Worlds: Accessing Emerging Economies via Developed Markets
Foreign currencies, political risks, legal frameworks and cultural differences represent obstacles to investors who want to diversify internationally. Simultaneously, recent studies suggest that the correlations of developed and developing stock market indices rise, diminishing the potential of diversification gains. Bae, Elkamhi and Simutin (2016) investigate an alternative approach to international diversification that circumvents the use of emerging market equity funds, and suggest that diversification benefits are rather under- than over-stated.
The authors propose to invest in emerging economies by means of developed market equities in industries with strong emerging market export ties. In line with this, twenty emerging economy indices are created, composed of developed market stocks weighted based on the country-industry export data. These indices represent one emerging economy each and are obtained by maximizing the exposure to the respective emerging economy while simultaneously minimizing the exposure to all other emerging economies.
The potential gains of this form of diversification are large: Seventeen out of twenty emerging economy indices deliver positive and significant alphas between 3 and 7% annually. The evidence of outperformance remains solid after controlling for various risk factors.
The investment approach would have been particularly beneficial in times of crisis. Whereas crisis years are characterized by a flight out of emerging market equities, developed market firms exposed to foreign markets are not subject to similar price-depressing dynamics.
Including these emerging economy indices in a portfolio could have substantially improved the efficient frontier. In contrast, an inclusion of equity indices composed of emerging market stocks shows little diversification benefits.
As the title states, Bae, Elkamhi, and Simutin (2016) suggest that the best of both worlds in terms of international diversification might be attainable for institutional investors. Instead of investing in emerging market equities, institutions could get a more comprehensive, beneficial exposure to emerging economies by strategically compiling investments in developed markets in a way that captures and weighs emerging market export activities.