Emerging Markets = Diversification?

July 22, 2008

 

The resulting correlation coefficients are given in Exhibit 2. While the numerical values of correlation coefficients may range from 1.0 to -1.0, the majority of the coefficients in Exhibit 2 exceed 0.6 and often exceed 0.7. (Similar results are obtained if prices are used instead of returns. For example, the correlation coefficient relating the SPY and ADRE is 0.9049 over five years; the correlation coefficients are 0.958 and 0.974 over four years for EEM and EZA, respectively.)

Implication

To achieve diversification, the numerical values of the correlation coefficients relating the returns on the alternative investments need to be small or even negative. The correlation coefficients calculated in this study are relatively large and inconsistent with prior research. Based on these results, investing in emerging market ETFs traded on American securities markets no longer offers much potential to diversify a portfolio consisting of American stocks.

 

Exhibit 1: ETFs Included In The Study

Fund
Ticker
BLDRS Emerging Markets 50 ADR Index Fund (NasdaqGM: ADRE)
SPDR S&P BRIC 40 ETF (AMEX: BIK)
iShares MSCI BRIC Index Fund (NYSEArca: BKF)
Claymore/BNY BRIC ETF (AMEX: EEB)
iShares MSCI Emerging Markets Index Fund (NYSEArca: EEM)
iShares MSCI South Africa Index Fund (NYSEArca: EZA)
First Trust ISE Chindia Index Fund (NYSEArca: FNI)
SPDR S&P Emerging Middle East and Africa (AMEX: GAF)
SPDR S&P Emerging Asia Pacific (AMEX: GMF)
SPDR S&P Emerging Markets (AMEX: GMM)
SPDR S&P Emerging Europe (AMEX: GUR)
iPath MSCI India Index ETN (NYSEArca: INP)
PowerShares DWA Emerging Market Technical Leaders (NYSEArca: PIE)
Market Vectors Russia (NYSEArca: RSX)
Vanguard Emerging Markets (AMEX: VWO)

 

 

Exhibit 2: Correlation Coefficients Relating ETFs And S&P 500 Returns
  Number of Years

 

5.0

4.5

4.0

3.5

3.0

2.5

2.0

1.5

1.0

0.5

ADRE
0.710
0.702
0.693
0.709
0.700
0.659
0.658
0.616
0.675
0.815
EEM
 
0.723
0.700
0.704
0.681
0.670
0.664
0.631
0.695
0.841
EZA
 
0.572
0.582
0.581
0.570
0.562
0.587
0.505
0.634
0.735
VHO
         
0.710
0.633
0.571
0.613
0.719
EEB
               
0.617
0.810
INP
               
0.485
0.478
GAF
                 
0.772
GMF
                 
0.735
GMM
                 
0.734
GUR
                 
0.625
RSX
                 
0.632
FNJ
                 
0.801
BIK
                 
0.791
 
Sources
Adorna, Joseph, Andrew Carver and Herbert B. Mayo, "Achieving Superior Diversification With Portfolios Of ETFs," on www.indexuniverse.com, January 25, 2008.
Evans, John and Stephen Archer, "Diversification and the Reduction of Dispersion: An Empirical Analysis," Journal of Finance, 1968, Vol. 23, pp. 761-767.
Goetzmann, William N., Lingfeng Li, and K. Geert Rouwenhorst, "Long-Term Global Market Correlations," Journal of Business, 2005, Vol. 78 #1.
Keppler, Michael and Martin Lechner, Emerging Markets (Chicago: Irwin Professional Publishing, 1997).
Markowitz, "Portfolio Selection," Journal of Finance, 1952, Vol. 7, pp. 77-91.
Mobius, J. Mark, Mobius on Emerging Markets, (London: FT Pitman Publishing, 1996).

Agnieszka Baczyk is an operations analyst with Merrill Lynch. Dr. Herbert Mayo is a professor of finance at The College Of New Jersey.

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