Emerging market investments  can add value to one’s portfolio.
On the one hand, emerging market assets provide potential diversification benefits that help lower overall portfolio risk.
At the same time, emerging markets offer potentially higher returns than investments in developed markets. This helps enhance overall portfolio expected returns.
Lower portfolio risk, higher expected returns, count me in!
Well, like any investment, there are always a few strings attached.
The advantages of diversification into global markets today are less than they were 20 years ago. This is due to factors including: the ever increasing level of globalization, closer economic ties between countries, and improved information flows for investors.
Today we will take a look at the risk reducing benefits in adding emerging market assets to one’s portfolio. And the issues to watch out for.
Emerging Markets May Diversify Portfolio To Reduce Overall Risk
As we saw in our look at diversification, asset correlations  (i.e., connection between the assets) impact overall portfolio risk.
By adding assets with low or negative correlations to an existing portfolio, it reduces portfolio risk to some extent.
How Much Diversification Depends on Amount Added and the Inter-Asset Correlation
The exact amount depends on the amount of new asset being added. Obviously, if you add stock worth $1000 to a portfolio with a total value of $1 million, its impact will be smaller than if the entire portfolio was worth $2000.
The amount of risk reduction also is impacted by the inter-asset correlation. The lower the correlation between portfolio assets, the lower the overall portfolio risk.
Developed Markets May Have Close Economic Ties and High Correlations
Often emerging market assets have lower correlations with developed countries than do developed countries between themselves.
For example, Canada and the U.S. are closely related in many economic areas. If the U.S. economy suffers, there will be a significant impact on Canada. The same close relationship exists between European Union countries like France and Germany.
Developed nations tend to have similar markets, trading relationships, rule of law, consumers that enjoy similar products, etc. As such, systematic risk factors  that impact one developed country can have an impact on all. The closer the relationship between two countries, the higher the inter-country correlation.
As the economic ties begin to fade, correlations between the countries fall.
Emerging Markets May Have Less Economic Ties to Developed Markets
With emerging market countries, often the connection between a specific country (e.g., Morocco) and your home country (e.g., Canada) is small. So you can get diversification benefits by adding emerging market assets to your investment portfolio.
The lack of connection between an emerging market and your home country may be due to a variety of factors. Proximity, lack of trade treaties, disposable income in the emergent market, resources, can all weaken ties (and correlations) between your country and the emerging market. For diversification purposes, this is good.
But Not Always
Even though one country is labelled an emerging market, its unique relationship with a second country determines its correlation.
Not simply whether one is developed and the other emergent.
This is a crucial point to remember.
You Must Always Compare The Specific Countries
Distance and economic development are often keys to correlations between countries.
The correlation between Mexico and the U.S. is higher than between the U.S. and Germany simply because of physical proximity and the resulting ties and trade. The same holds true between Germany and the Poland. But the relative correlations between Germany and Mexico or the U.S. and Poland will be smaller due to distance and lack of common borders.
Also, some large economies (e.g., Brazil, China, India, Russia) are included as emerging markets. Although considered emerging markets, these countries have close economic ties to many developed nations.
For example, China holds a huge amount of U.S. debt. And the U.S. is a big importer of Chinese made goods. Even though the two countries are physically far apart, their economic ties lead to a higher correlation than might otherwise expected.
So, in many instances, adding an emerging market investment to your portfolio will reduce your overall portfolio risk. But do not blindly assume that emerging market assets have lower correlations than other international assets. You need to dig a little deeper to see the specific relationship between the markets. Sometimes, the benefits will not be there.
The World Continues to Shrink
As the world continues to become smaller through increased globalization and information flow, diversification benefits have fallen.
Just look around you to see this is true. Not that many years ago, foreign automobiles in the U.S. were relatively rare. Today, Japanese, Korean, German, and others are the norm.
Consider Starbucks. Almost impossible to believe, but prior to 1996 there were no Starbucks outlets outside the U.S. It was only in 1998 that Starbucks opened a store in the United Kingdom. 13 years later, I cannot walk more than a block in downtown London without stumbling across a mermaid like sea siren. Today Starbucks operates in 57 countries with over 17,000 stores. And approximately 1000 of those are in the U.K.
Also, new free-trade agreements (FTAs) continue to develop that serve to enhance economic ties. In 2011, Canada completed a FTA with Colombia, concluded negotiations on a FTA with Honduras, tabled legislation on FTAs with Panama and Jordan, and continues to negotiate on a FTA with India. That Stephen Harper has been a busy fellow.
Complicating things further is that the German car driven by the Australian may have been built in the USA or South Africa. That Apple iPod bought by a Swiss person was made in China. And the American is getting his assistance from JPMorgan Chase or AT&T via a call centre employee in the Philippines.
As more and more companies shift resources to take advantage of lower cost jurisdictions, they increase their operations in emerging markets. This increases ties as well as correlations.
But There Are Exceptions
In general, the world is shrinking, which means a trend towards higher correlations between countries. But sometimes circumstances arise that reduce the current connections.
Greece is intimately connected to the European Union through the Euro. If it leaves the Euro, as may happen, the correlation between Greece and other Euro countries will fall. Probably not much given the physical proximity of European countries, but it will decrease to some degree.
Or look at the current situations in Egypt and Pakistan. The U.S. has had close military and economic assistance ties to each country. But as political circumstances change in both countries, there is a strong probability that ties between these nations and the U.S. will decrease.
Changing correlations is not necessarily a one-way street.
Including emerging market assets in one’s portfolio can provide diversification benefits by reducing overall portfolio risk.
But it is not the slam-dunk that it was 15 or 20 years ago.
You need to examine any emerging market in direct comparison to your home region. Australians will have closer economic ties to China, Indonesia, and the Philippines than a Brit.
And a specific emerging market may have a higher correlation to your existing portfolio than some developed markets. Japan has closer ties to China than it does to Sweden.
Finally, never forget that the world is fluid. As global events change, so too can correlations.
When considering adding emerging market assets in your existing portfolio, do your homework.
Make certain that the potential asset actually provides a diversification benefit by reducing overall portfolio risk.
And once it is in the portfolio, monitor world events to ensure that it continues to provide these benefits over time.
Next up, a look at how emerging market assets can enhance portfolio returns.