International Diversification in a Troubled World: Do Frontier Assets Still Improve the Efficient Frontier?

Abstract

Although the economic recovery seems off to a stronger start than anticipated earlier, there are considerable differences between the various regions. Emerging and developing economies are expected to benefit from strong internal demand while for most advanced economies the recovery is expected to remain sluggish. These expectations support the hypothesis that decoupling may be occurring between the developed world and the emerging/frontier world. Considering frontier and emerging market assets in the portfolio construction process might therefore lead to considerable diversification benefits and superior performance. Covering the time period from January 1, 2007, to February 26, 2010, we find that frontier markets, in particular, cannot fully live up to expectations. Although they generally provide useful diversification benefits, it strongly depends on the composition of the respective frontier indices whether they can be of help when it gets ugly. If the wrong index is chosen, its return and correlation structures may simply break down and its performance may be surprisingly poor. Portfolio managers therefore should carefully review what exactly those indices intend to mirror and not rely on information about correlations that does not consider extreme events. Furthermore, although a frontier market index might have low correlations with other potential investment objects, the achievable reduction in terms of standard deviation may not be sufficient to compensate for the lower returns that come along with it.