Emerging markets of South-East and Central Asia: Do they still offer a diversification benefit?

Abstract

The aim of this paper is to check whether, despite the growing world economic integration and progressive lifting of capital controls, emerging markets still offer international investors a valuable diversification benefit. The study covers emerging markets from South-East Asia (Indonesia, the Philippines and Malaysia) and Central Asia (Korea, Taiwan, China and India) over the period 31st August, 1999 to 29th August, 2003 (a period characterised by both bull and bear stock markets), with the US, the UK and Japan as the reference ‘established’ markets. It uses several state-of-the-art techniques: multivariate cointegration and vector autoregression models (VARs) with the analysis of variance decomposition (VDC), time-varying correlations with Kalman filter models and the computation of conditional variances and covariances to devise optimal investment portfolios.

The existence of one cointegrating vector is found between the emerging markets considered and each ‘established’ market. Furthermore, the results for the time-varying parameter models using Kalman filters show that all emerging markets have become more closely integrated with the Japanese market. In contrast, the results for the US and UK time-varying parameter models indicate that several emerging markets have seen their level of integration remain steady or decline over the review period. Finally, the results of the conditional covariance approach indicate that international diversification was still beneficial for a US investor during that period. In addition, it is shown that an optimised portfolio containing emerging market stocks outperformed a portfolio consisting purely of US stocks over the out-of-sample period 1st September, 2003, to 5th July, 2004.