The relevance of emerging markets in portfolio diversification: Analysis in a downside risk framework

Abstract

During the global financial crisis of 2008, emerging markets declined almost to the same extent as developed markets, casting doubts on their ability to provide diversification benefits. This article aims to assess the benefit of adding the volatility index, as an asset class, instead of emerging markets to the domestic portfolios of US and UK investors. The results show that for both US and UK investors, portfolios comprising volatility-based contracts outperform emerging markets portfolios on the basis of portfolio performance metrics, such as the Sortino ratio, the Adjusted Sharpe ratio and the Stutzer index. The results imply that US investors seeking risk reduction have an alternative investment opportunity in volatility-based contracts rather than investing in emerging markets. Investing in emerging markets is fraught with political and exchange rate risks, whereas investing in the VIX is free of these risks. Currently, there are no exchange-traded products on the FTSE 100 VIX. This study makes a case for introducing them.