Global equity investing: An efficient frontier approach

• Author: Duncan Sinclair,Niso Abuaf,Tracyann Ayala
• Date: 01 May 2019
• Published date: 01 May 2019
• DOI: http://doi.org/10.1111/infi.12146

© John Wiley & Sons Ltd wileyonlinelibrary.com/journal/infi International Finance. 2019;22:70–85.

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DOI: 10.1111/infi.12146

ORIGINAL MANUSCRIPT

Global equity investing: An efficient frontier

approach

Niso Abuaf

1,2

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Tracyann Ayala

2

|

Duncan Sinclair

1

1

Samuel A. Ramirez and Co., New York,

New York

2

Pace University, New York, New York

Correspondence

Niso Abuaf, Lubin School of Business,

Pace University, One Pace Plaza, New

York, NY 10038.

Email: nabuaf@pace.edu

Abstract

The goal of this paper is to test em pirically whether

emerging-market portfol ios appear on the mean-varian ce

efficient frontier, inve stigate whether particular ma rkets

provide better diversifica tion benefits, and to ascertain if

these relationships are ti me-invariant. Countries tha t are

more economically independe nt from the United States

(as measured by relatively low c orrelations of their stock

markets to the United States, or intuiti vely as being

markets whose real and monetar y shocks are seemingly

independent of the United S tates) provide better divers i-

fication for US investors. Though these relationshi ps are

time-dependent, Mexico and Chin a appear to be the most

important diversifiers. W e also compare the results of a

mean-variance framewor k versus a mean-VaR (value-at -

risk) framework that may be more app licable when

return distributions are non -normal, for the period May

1988–2018, and find that th ere are no significant

differences.

1

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INTRODUCTION

International portfolio diversification has been increasing in importance among US institutional and

private investors since the early 1970s (Solnik & McLeavey, 2009). According to Solnik and

McLeavey (2009), ‘In 1974, the New York Stock Exchange was the only significant market in the

world, representing 60 percent of world market capitalization of less than $1 trillion. The size of the

world market multiplied by a factor of 50 in the next 32 years, and the share of U.S. equity moved from

60 percent to less than 30 percent in 1988 and back to 40 percent by the end of 2006’.

ABUAF ET AL.

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Theoretically speaking, international diversification allows investors to reduce the total risk of their

portfolios, given a return expectation; or increase their return expectation, given a risk (standard

deviation of returns) expectation. This theoretical assertion exists because international stocks are

not perfectly correlated. Markowitz (1952), the father of modern portfolio theory, posits that

diversification benefits are higher when there is a low correlation among the portfolio's assets. Further

studies have extended this research by exploring the positive diversification impact of international

securities on a portfolio due to the domestic and international positions' low correlations (Grubel, 1968;

Levy & Sarnat, 1970; Solnik, 1974). Naturally, international returns will also need to be adjusted for

exchange-rate movements.

As stated in De Fusco, McLeavey, and Runkle (2007), a portfolio is mean-variance efficient if it has

the highest level of expected return for a given level of risk. The set of all efficient portfolios is called

the efficient frontier.

The benefits from diversifying internationally have been decreasing due to the increasing

correlations among stock markets, which may be the result of global capital markets becoming more

integrated (Longin & Solnik, 1995). Bekaert, Hodrick, and Zhang (2008) explain that events such as

the implementation of the euro and the integration of European Union countries and NAFTA have

probably created regionally integrated markets. Other factors such as independence of national

economies, fiscal and monetary policies, varying regulatory frameworks, and national factor

endowments may cause less than perfect correlations among national economies and stock markets,

suggesting that international diversification enhances the domestic efficient frontier.

Emerging market economies, in particular, have become more attractive to investors in the late

1990s when these markets were reformed following events such as the 1997 Asian financial crisis and

the 1998 Russian debt crisis. Additionally, these markets may provide better returns for US investors

because emerging markets often have a low correlation with the US stock market.

The literature suggests that compared with developed markets, emerging markets exhibit higher

volatility than developed markets, with asymmetric return distributions and increasing return

correlations in times of crisis, but they also exhibit higher return opportunities because of early growth

stages of their economies.

While investing internationally in general, and in emerging markets in particular, may pose

additional risks (volatility, liquidity, political risk, foreign-exchange risk) and costs, the general

consensus among academics and practitioners is that international diversification pays off. Stated

differently, academics have long maintained that international diversification provides an efficient

frontier that dominates the domestic-only efficient frontier because domestic returns are not perfectly

correlated with international returns. The goal of this paper is to determine empirically which emerging

market portfolios will appear on the efficient frontier.

Our tests use indexes built in discrete increments for the time period 1990–2014 to find the efficient

frontier. By utilizing indexes, the applicability of these findings extends to individual investors who

can easily and at a low cost invest in exchange-traded funds (Jacobs, Müller, & Weber, 2013). The

results show that the efficient frontier does benefit from the inclusion of emerging markets, but there is

also the need to analyse macroeconomic conditions prior to investment.

We create efficient frontiers with portfolios of specific markets built in discrete increments for the

time period 1990–2014 by utilizing seven country indexes. As we would expect, the findings point to a

better diversification of benefits from countries which are economically independent from the United

States. Both sets of tests are performed multiple times utilizing different time periods to see the impact

of timing on the returns. The various time periods include long spans of time, shorter time periods, and

before and after the 2000 and 2007 crises. These results, though, are not time-invariant in that investors

should keep an eye on macroeconomic developments.