Emerging Market Diversification Benefits: Stock Funds versus Currency Funds

Abstract

We examine the empirical evidence on the diversification benefits of adding investable emerging market currency fund exposure to a portfolio that is otherwise internationally-diversified across developed markets, and do likewise with an emerging market equity fund. We find that emerging market equity exposure does not offer diversification benefits, while, in contrast, emerging market currency funds do offer diversification benefits. These results are explained in part by the fact that a large proportion of the currency fund return variance is driven by idiosyncratic risk, and that proportion has not diminished over time. Furthermore, unlike emerging market equity returns, emerging market currency returns have not become more integrated over time with an internationally-diversified developed market portfolio. The results of a spanning test support these findings and suggest that currency funds favorably shift the efficient frontier. We conclude that emerging market currency funds are an effective investable vehicle to realize the diversification benefits of emerging market investing.

TOPICS: Security analysis and valuation, currency, emerging markets, portfolio construction

Key Findings

• ▪ Emerging market currency funds offer better diversification benefits than do emerging market equities.

• ▪ Emerging market currency fund returns are not becoming more integrated with developed market returns over time.

• ▪ The results of the diversification benefits analyzed using Sharpe ratios (Sharpe 1964) are consistent with the results of the benefits analyzed using spanning tests.