The Best of Both Worlds: Accessing Emerging Economies via Developed Markets

• Author: REDOUANE ELKAMHI,JOON WOO BAE,MIKHAIL SIMUTIN
• Date: 01 October 2019
• Published date: 01 October 2019
• DOI: http://doi.org/10.1111/jofi.12817

THE JOURNAL OF FINANCE •VOL. LXXIV, NO. 5 •OCTOBER 2019

The Best of Both Worlds: Accessing Emerging

Economies via Developed Markets

JOON WOO BAE, REDOUANE ELKAMHI, and MIKHAIL SIMUTIN∗

ABSTRACT

A growing body of evidence suggests that the benefits of international diversification

via developed markets have declined dramatically.While emerging markets still offer

diversification opportunities, their public equity indices capture only a fraction of

emerging countries’ economic activity. We propose a diversification approach that

exploits the global connectedness of developed countries to gain exposure to emerging

countries’ overall economies rather than their shallow equity markets. In doing so,

we demonstrate that developed markets still offer substantial diversification benefits

beyond those available through equity indices. Our results suggest that relying on

equity indices to assess diversification benefits understates diversification gains.

INTERNATIONAL DIVERSIFICATION IS A FUNDAMENTAL concept in both asset pric-

ing and portfolio management. To analyze the potential benefits of investing

abroad, researchers often rely on foreign equity market indices where the con-

stituent firms are publicly traded.1This approach can significantly understate

potential diversification gains because publicly listed firms account for only a

small share of the overall economy in many countries, especially in emerging

markets (see Bekaert and Harvey (2014) and Figure 1). For example, just 74

∗Joon Woo Bae is at the Weatherhead School of Management at Case Western Reserve Uni-

versity. Redouane Elkamhi and Mikhail Simutin are at the Rotman School of Management at the

University of Toronto. The authors do not have any potential conflicts of interest to disclose, as

identified in the Journal of Finance Disclosure Policy. For helpful comments, we thank Stefan

Nagel and Ken Singleton (Editors); two anonymous referees; the Associate Editor; Pat Akey, Matt

Billett, Francesca Carrieri, Pierre Collin-Dufresne, Craig Doidge, Hitesh Doshi, Cam Harvey,Antti

Ilmanen, Wenxi Jiang, Raymond Kan, Lasse Heje Pedersen, Raunaq Pungalia, Stephan Siegel,

Sheridan Titman, and seminar participants at Concordia University, McMaster University, the

SKK University, Southern Methodist University, the University of Oklahoma, the University of

Alberta, the University of Toronto, Arizona State University, the University of Washington, Case

Western Reserve University, the Bank of Canada, the Alliance Bernstein Quantitative Research

conference, the China International Finance conference, the International Centre for Pension Man-

agement discussion forum, the Society for Financial Studies Cavalcade, and the Norther Finance

Association conference.

1A vast literature explores various dimensions of international diversification, including its

sources, benefits, and time-variation, as well as the propensity of different investors to engage in

it and new econometric methods. See Grubel (1968), Levy and Sarnat (1970), Solnik (1974), Chan,

Karolyi, and Stulz (1992), Ferson and Harvey (1994), Heston and Rouwenhorst (1994), Chang,

Eun, and Kolodny (1995), Shawky,Kuenzei, and Mikhail (1997), Griffin and Karolyi (1998), Chan,

Covrig, and Ng (2005), Eun, Huang, and Lai (2008), and Christoffersen et al. (2012).

DOI: 10.1111/jofi.12817

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2580 The Journal of Finance R

1990 1995 2000 2005 2010 2015 2020

0

0.2

0.4

0.6

0.8

1

A. Share of world GDP

Developed countries' share of world GDP

Emerging countries' share world GDP

B. Emerging markets' share of world market capitalization

1990 1995 2000 2005 2010 2015 2020

0

0.05

0.1

0.15

0.2

0.25

0.3

Figure 1. Economic growth and market capitalization of international markets. In this

figure, Panel A plots the proportion of world GDP attributable to developed and emerging markets,

while Panel B shows the share of world market capitalization attributable to emerging markets.

GDP data are from the International Monetary Fund, and market capitalization data are from the

World Bank. The developed markets are Australia, Canada, France, Germany, Japan, the United

Kingdom and the United States. The emerging markets are Argentina, Brazil, Chile, China, Colom-

bia, the Czech Republic, Egypt, Hungary, India, Indonesia, Malaysia, Mexico, Morocco, Pakistan,

Peru, the Philippines, Poland, South Korea, Thailand, and Turkey. (Color figure can be viewed at

wileyonlinelibrary.com)

firms are publicly listed in Morocco, which provides a narrow window to ac-

cess the economy. Even in the world’s second-largest economy, China, the stock

market plays a relatively small role (Allen, Qian, and Qian (2005)).

In this paper, we propose diversifying into emerging countries via a new

route, in particular, one that targets countries’ overall economies rather than

just their equity indices. At the root of our “economic diversification” is the idea

that we can gain proxy exposure to nontraded assets by using publicly listed

securities. In the context of international diversification, we operationalize this

idea by proposing that investing in developed market firms that trade with an

emerging country provides exposure to the economic activity of that country.

For example, investing in public Australian companies that export iron ore to

Indonesia can offer exposure to Indonesian infrastructure projects. We show

that this approach delivers diversification benefits not attainable by investing

directly in publicly traded emerging market firms or indirectly in a portfolio of

Accessing Emerging Economies via Developed Markets 2581

developed market firms constructed to mimic emerging market equity indices

(see, for example, Errunza, Hogan, and Hung (1999)).2

To implement our diversification method, we use the UN Comtrade database

to obtain industry level information on exports from each developed country

to a given emerging country. Our main data set includes seven developed and

20 emerging countries over the 1990 to 2014 period. For each developed coun-

try, we use its publicly traded firms to create industry portfolios. We then use

data on exports from these industries to emerging countries to obtain portfo-

lio weights that result in indices that access a single emerging economy but

have negligible exposure to other countries (henceforth “EE indices”). These

EE indices comprise industry portfolios from the seven developed markets and

do not contain emerging market equities. Naturally, countries with closer eco-

nomic ties to a given emerging country, as evidenced by higher exports to that

country, have higher weights in its EE index.

To evaluate our methodology, we benchmark our analysis against the ap-

proach used in prior literature to explore the attractiveness of developed mar-

ket investments for diversification into emerging markets. For example, Er-

runza, Hogan, and Hung (1999) take the perspective of a U.S. investor and use

regression-fitted returns to mimic equity indices of emerging countries with

investments available in the United States. Building on their approach, we

use industry portfolios, mutual funds, multinationals, and other investments

available in multiple developed markets to construct portfolios that mimic

emerging market equity indices (henceforth “EM-mimicking portfolios”). Just

like our EE portfolios, these indices use investments available in developed

markets so as to avoid the challenges of investing directly in emerging coun-

try equities and hence provide the most natural benchmark against which to

compare the performance and diversification benefits of the EE portfolios. The

use of this benchmark highlights a crucial point of distinction between our

paper and prior research: our EE indices are constructed to obtain exposure to

emerging countries’ overall economies rather than their equity indices,which

have been the focus of earlier literature.

We start the analysis by showing that our EE portfolios do indeed provide

deeper access to emerging economies than do EM-mimicking indices. In par-

ticular, regression analysis shows that the performance of our EE portfolios

is significantly associated with various proxies for emerging country economic

activities, including growth in GDP, consumption, credit to the private sec-

tor, and industrial production. We also confirm that the degree of exposure to

the growth of economic activities in emerging countries is stronger for our EE

indices than it is for EM-mimicking portfolios.

Our main empirical findings can be summarized as follows. First, we

show that developed markets still offer diversification opportunities. The

2Our route is also attractive because it mitigates myriad other challenges associated with

investing directly in emerging markets, such as small depth of their public equity markets,

weak shareholder rights, political instability, lack of legal protection, and deficiency in accounting

standards. Karolyi (2015) provides a detailed review.