Are the Emerging Markets Relevant for Portfolio Diversification?

Abstract

In the recent financial meltdown along with the developed markets emerging markets too declined sharply casting doubts on their ability to provide diversification benefits. One of the stylized facts of volatility is its negative correlation with the equity market, this in conjunction with the launching of securities for trading volatility lead to the emergence of a new asset class for portfolio diversification. From the US investors’ perspective this study investigates whether a domestic portfolio along with exposure to an alternative asset class like volatility index (VIX) fares better than diversifying by investing in emerging markets. The study finds that the Sharpe ratios of both the strategies are not statistically different under a naive asset allocation strategy. But 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 beneficial as the magnitude and direction of the correlation is predictable while the emerging markets correlations are not only positive but also the size of the correlation coefficient is increasing. Hence US investors in pursuit of risk reduction have an alternative investment opportunity in volatility based contracts.