Emerging markets, downside risk and the asset allocation decision

Abstract

This study examines the use of downside risk measures in the construction of an optimal international portfolio, with particular reference to the estimated allocations in emerging markets and the out-of-sample performance of the optimal portfolios. The use of downside risk measures is assessed due to the problems of using a conventional mean-variance analysis approach in the presence of the non-normality often found to be present in emerging market data. The data set used consists of the MSCI indices for developed equity markets and the IFC data set on emerging markets. The primary component of the paper consists of the construction of optimal portfolios under both mean-variance and downside risk frameworks. In addition, the use of Bayes–Stein estimators is also assessed, in an attempt to reduce estimation error. The resulting estimated allocations are then used to assess the out-of-sample performance of the optimal portfolios. The results indicate that for risk-averse investors the use of downside risk measures can result in significant improvements in performance.