Diversifying and Rebalancing Emerging Market Countries

Abstract

This article discusses the diversification and rebalancing of emerging market countries. Emerging country risks are high and relatively uncorrelated, and the cap-weighted index is concentrated. In the absence of prior information on returns, these characteristics lead one to expect that a structured rebalanced portfolio will outperform a capweighted one over the long term. The authors study this phenomenon with a theoretical model of portfolio returns—quantifying performance advantages and leading to a better understanding what drives them. It turns out that even though emerging markets suffer high transaction costs and unreliable information, pragmatic portfolio implementations with relatively little trading are still possible. For a real implementation, the authors review how the key drivers of excess performance have evolved during the recent increase in globalization.