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09/07/2010

Free Lunch in Emerging Markets: Evidence from Latin America


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What does a US investor stand to gain from international portfolio diversification? This analysis discovers that diversification benefits would have made it beneficial for an investor with any risk profile to include emerging Latin American market indexes in a US portfolio from 1992 to 2006, rather than investing solely in S&P.

Although several studies exist on the benefits of international diversification (e.g., Grubel 1968; Levy and Sarnat 1970; Lessard 1973; Odier and Solnik 1993; and Eun and Resnick 1994), the benefits to the foreign investor in emerging Latin American markets are still under-researched. In addition to the question of whether it’s worthwhile for US investors to include emerging Latin American market equities in their portfolios, there is also the issue of what the optimal portfolio mix for such investors would be.

REVIEW OF THE LITERATURE

The argument that international portfolio diversification may reduce risk while holding expected return constant was posited since Grubel (1968), Levy and Sarnat (1970), and Solnik (1974); but to date, the issue remains a controversial one. Grubel’s study involved the use of monthly data on stock-market indexes of ten industrial countries, including the US, for the period 1959–1966. Adopting the perspective of the US investor, Grubel finds evidence that such an investor could gain through international diversification.

Early studies like this were criticized on methodological grounds. For example, Agmon (1972) suggests that Grubel’s use of country indexes inadequately measured the potential gains from international diversification, since the composite market index does not capture all the possibilities for diversification within the local context. However, subsequent research (e.g., Lessard 1973; Solnik 1974) that avoided those problems still found results consistent with Grubel’s. Levy and Sarnat (1970), for instance, take a much larger sample of 28 markets, both developed and emerging. Not only do they find diversification gains for the US investor, but they discover that the inclusion of emerging markets increases the diversification benefits substantially.

To test whether diversification gains are specific to the investor perspective, Eun and Resnick (1994) adopt the perspective of both US and Japanese investors. Their 1979–1989 study finds that both investors benefit, the US investor more so. Additionally, the researchers note that while the benefit to the US investor was in the form of higher return, the Japanese investor’s gain was mainly through risk reduction. More recent studies have also found evidence in support of international diversification. In a study of seven European stock markets, Solnik (1974) finds that the variability of return on an internationally well-diversified portfolio would be one-tenth as risky as a typical security and half as risky as a well-diversified portfolio of US stocks with the same number of holdings.

Nevertheless, opponents of the theory point to the segmented nature of the capital markets before 1980. They argue that restrictions on the flow of capital among markets, high costs, and information difficulties created the false appearance of gains from international investing. Blackman and Holden (1994) purport to show that gains from international portfolio diversification in the developed markets were actually lower in the 1980s than they were a decade earlier. In a more recent study, Hanna et al. (1999) could not find evidence of diversification gains to the US investor in their study of six equity markets (France, Germany, Italy, Japan, Canada, and the UK) for the period 1988–1997. They attribute their peculiar results to the higher correlation between the US and the other countries, and to the comparatively higher risk-adjusted returns of the US relative to the other six markets.

Bartram and Dufey (2001) suggest that the correlation of returns between foreign and domestic securities tends to be lower than between purely domestic securities because, in the latter case, the returns are in part affected by mainly national events such as interest rates. These researchers suggest that although fiscal, monetary, trade, tax, and industrial policies affect a country as a whole, they may vary considerably across different countries. Hence regional economic shocks induce large, country-specific variation of returns.

DATA AND METHODOLOGY

For the empirical analysis, IFCI (International Finance Corporation Investable) stock-index data for Argentina, Brazil, Chile, Colombia, Mexico, and the US were used in computing monthly returns in US dollars for the period 1992–2006. Twelve portfolios were constructed based on a three-year rolling window. These were optimized in the Markowitz mean-variance framework and their performance was evaluated using the Sharpe ratio for both the “average” and “conservative” investor’s perspective.

FINDINGS AND ANALYSIS

The aggregated results of Figure 1 show the portfolios outperforming S&P over the sample period. The relatively conservative US investor who held a portfolio consisting of a combination of S&P Composite and Latin American market indexes over the period 1992–2006 would have benefited through diversification. Such an investor’s return would have been 68.57% greater than had s/he invested solely in S&P. Furthermore, because the increase in risk (44%) associated with this higher return is less than proportionate, this investor would have gleaned both increased return and reduction in risk. The Sharpe ratio of this investor’s portfolio is 62.15%, while that of the home asset is 48.06%.

Freelunch-figure1 
Figure 1: Portfolio Performance (Aggregated)
Source: Amedzro, 2008. 
Figure 1 demonstrates the performance in aggregate terms of the various portfolios versus the S&P Composite from the perspectives of both the average and conservative investors. The comparison is based on the Sharpe ratio computation obtained as the portfolio’s excess return as a ratio of its standard deviation.

Similarly, for the average US investor, the increase in portfolio return was 55.71% with less than proportionate increase in risk (31.72%). Here again, the investor would have benefited through both an increase in return and a reduction in risk. The portfolio’s Sharpe ratio (56.91%) compares favorably with that of the S&P Composite. To obtain these results, however, the investor would have to adjust the portfolio in accordance with weightings obtained for each portfolio over the period.

Figures 2 and 3 compare the performance of the 12 portfolios and the S&P Composite one year after the formation of the portfolios. While the results in Figure 2 show performance from the perspective of the relatively conservative US investor, Figure 3 examines performance from the perspective of the average US investor. From both perspectives, the S&P Composite outperformed the portfolios on a yearly basis approximately 33.3% of the time. This occurred from 1995 through 2001 and in 2006. However, from 2002 to 2005, the portfolios outperformed S&P 33.3% of the time. Changing the risk preference of the investor did not alter the results. For the period 1998–2001, the portfolios and the S&P performed equally well.

Freelunch-figure2
Figure 2: Performance of Optimal Portfolios versus S&P Composite Index from the Perspective of a Relatively Conservative US Investor

Source: Amedzro, 2008. 
Figure 2 shows the performance of the various portfolios versus the S&P Composite from the perspective of the conservative US investor. The comparison is based on the Sharpe ratio computation obtained as the portfolio’s excess return as a ratio of its standard deviation.

Freelunch-figure3 

Figure 3: Performance of Optimal Portfolios versus S&P Composite Index from the Perspective of an Average US Investor
Source: Amedzro, 2008. 
Figure 3 shows the performance of the various portfolios versus the S&P Composite from the perspective of the average investor. The comparison is based on the Sharpe ratio computation obtained as the portfolio’s excess return as a ratio of its standard deviation.

IMPLICATIONS OF FINDINGS

In the wake of the increasing market integration, the US investor may still gain from diversification in Latin American equity markets, whatever his or her risk profile. The US investor will find it worthwhile to research these markets with a view to diversifying, especially during this period of financial turbulence in the US markets. Nevertheless, investors must be cautious, giving ample consideration to issues of political risk, transaction costs, and contagion in the markets they consider entering.

REFERENCES

Agmon, T. 1972. “The Relations among Equity Markets: A Study of Share Price Co-Movement in the United States, United Kingdom, Germany, and Japan.” Journal of Finance 27 (September 1972): 839–855.

Bartram, S. and G. Dufey. 2001. “International Portfolio Investment: Theory, Evidence, and Institutional Framework.” Social Science Research Network. (May 2001).

Blackman, S. and W. Holden. 1994. “Long-Term Relationship between International Share Prices.” Applied Financial Economics 4 (August 1994): 297–304.

Eun, C. and B. Resnick. 1994. “International Diversification of Investment Portfolios: US and Japanese Perspective.” Management Science 40 (January 1994): 140–161.

Grubel, H. 1968. “Internationally Diversified Portfolios: Welfare Gains and Capital Flows.” American Economic Review 58 (December 1968): 1299–1314.

Hanna, M., J. McCormack, and G. Perdue. 1999. “A Nineties Perspective on International Diversification.” Financial Services Review 8: 37–45.

Lessard, D. 1973. “International Portfolio Diversification: A Multivariate Analysis for a Group of Latin American Countries.” Journal of Finance 3 (June 1973): 619–633.

Levy, H. and M. Sarnat. 1970. “International Diversification of Investment Portfolios.” American Economic Review 60 (September 1970): 668–675.

Odier, P. and B. Solnik. 1993. “Lessons for International Asset Allocation.” Financial Analysts Journal 49 (March–April 1993): 63–77.

Solnik, B. 1974. “Why Not Diversify Internationally?” Financial Analysts Journal 30 (July–August 1974): 48–54.

–Laurence Amedzro is a lecturer at Regent University College of Science and Technology, Ghana. His research interests are in emerging-market finance and diversification.

This article was originally published in the Fall 2008 issue of the Investment Professional.

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