Evaluation of the benefits of invesment diversification to emerging financial markets with regression-based tests of mean-variance spanning : UK investors' perspective

Emerging markets have become the focus of attraction for international investors wishing to reduce portfolio risk. From the standpoint of US investors, several studies document evidence of substantial gains from diversification to emerging markets. Such studies employ one test method in examining the benefits from emerging market investment. In contribution to the literature on diversification to emerging markets this study investigates the benefits to UK investors from diversifying developed market portfolios to emerging financial markets using five tests of mean-variance spanning. The study is based on the equity return indices of five developed markets and fourteen emerging markets grouped first, as a standalone asset and second as four assets; South-east Asia, Latin America, Eastern Europe and Southern Africa. Preceding the empirical work are preliminary analyses that evaluate the expected returns, risk, correlations among the developed and the emerging markets and among the emerging markets themselves. The conclusions from this are that, compared to the developed markets, emerging markets have higher expected return and higher volatility. Besides, they have low correlation with one another and with the developed markets. By implications, the addition of emerging markets to developed market portfolios can be beneficial. In order to empirically substantiate these observations, four tests: the F-test, the likelihood ratio test, the Wald test, the Lagrangian multiplier test of spanning were employed to examine whether the addition of emerging market significantly shift the efficient frontier for the developed market portfolios. The conclusion from this is that, irrespective of the method of classifying the emerging markets or the version of the spanning test that is employed, UK investors can benefit from expanding developed market portfolios to emerging markets. However, the benefits are found to be traceable to specific markets within geographical regions, implying that investors would need to be selective in undertaking emerging market investment. As a further investigation, the returns are divided into two sub-period portfolios and an additional test procedure, the Generalised Methods of Moment Wald test, is introduced. The evidence from this analysis confirms that diversification to emerging markets is beneficial but that the benefits are time-varying. In addition, there are variations in the evidence from the different spanning tests. Finally, following Bekaert and Urias (1999) and Rowland and Tessar (2004) the economic significance of the benefits is examined based on the incremental Sharpe ratios that emanate from adding the emerging markets to the developed market portfolios. The results suggest that examining both the economic and statistical significance of diversification benefits is more informative. Overall, this study concludes that emerging markets provide diversification benefits to UK investors similar to that reported for US investors and that greater benefit derive from Eastern European and Latin American markets. The evidence of benefit seems to depend on the test method employed, the time period of the analysis, the appropriate choice of emerging market and whether or not there are short-sale constraints in the market(s) selected.