Emerging Markets: can diversification protect against contagion?
A central theory for any investor is that diversification should serve to reduce risk. Across countries, this is because most economic and market disturbances are country specific. Consequently, this would suggest that equity markets (and other assets) in different countries should be fairly uncorrelated. By spreading investment across a range of countries, or spreading eggs across multiple baskets, the idea is that portfolio risk is therefore reduced and returns increased.
However, our research has found that there are only limited benefits to be had from diversifying within EMs. There is some very high co-movement of equity indices within emerging markets, with certain regions moving together closely, and most individual EM equity indices seem strongly correlated to the MSCI Emerging Markets index. Although correlations appear to have reduced since the financial crisis in 2007 and 2008, it may be that the market has been distorted by the quantitative easing introduced to combat the financial fallout from the crash.
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