Are the Emerging Markets Relevant for Portfolio Diversification?

Abstract

In the recent financial meltdown, along with the slump in developed markets, emerging markets also declined sharply, bringing into doubt their ability to provide diversification benefits. One of the stylised facts of volatility is its negative correlation with the equity market, which in conjunction with the launching of securities for trading volatility, leads to the emergence of a new asset class for portfolio diversification. From the perspective of investors in the US, this study investigates whether a domestic portfolio along with exposure to an alternative asset class like volatility index (VIX) fares better than investing in emerging markets. The results show that for the minimum variance portfolios, there is a significant increase in Sharpe ratio when VIX is included, instead of the emerging markets to the domestic portfolio. Adding VIX is bene-ficial, as the magnitude and direction of its correlation is not only predictable but also stable. While the emerging markets correlations with developed markets are positive and increasing thereby diminish-ing the diversification benefits. Hence, US investors in pursuit of risk reduction have an alternative investment opportunity in volatility-based contracts.