The relatively low correlations among the developed markets and the Asian emerging markets and the contribution that comes from diversification into Asian emerging markets was well documented up until 1992, however this issue has not been examined since. This research report therefore re-examines the traditional benefits of diversification and the traditional benefits of including Asian emerging markets in international portfolio. The benefits of diversification are quantified from an Australia investor's perspective. The data is divided into sub-periods, so that the behaviour of stock price returns in the developed markets of Australia, U.S., U.K., and the emerging Asian markets of Taiwan, Korea, Malaysia, Philippines, Indonesia, and Thailand, can be comparatively analysed.
From our correlation analysis, the average correlation between all of the emerging Asian markets under investigation and the Australian market is relatively lower than the average correlations among the developed markets of U.S., U.K., and the Australian market. The results remain consistent with previous research even if we extend the correlation series beyond 1992. Therefore, the correlation result supports the argument by modern portfolio theory that substantial benefits can be gained by including emerging markets in international portfolios through the reduction in portfolio risk.
Further, we decide the sample period into three sub-periods to evaluate whether the correlations between the Australia market, the Asian emerging markets, and other developed markets have changed due to liberalisation of restrictions by Asian markets at the end of 1992 and the Asian Crisis in 1997. Therefore our data cutoff year was 1993 as a result of the events under investigation. That is, the correlations between the Australian market and the Asian emerging markets have increased as a result of these events. However, the effect on the correlations was only temporary and the correlations between the Australian market and the Asian emerging markets remained high only for a short period. Therefore, the result reinforced the potential benefit from international diversification.
Finally to quantify the potential diversification benefit an Australia investor could achieve from including emerging Asian markets in international portfolio, we constructed 6 portfolios based on simple design rules that selects different indexes to each portfolio. Our simple design rules in allocating indexes to portfolios are based on using historical and current period’s data on the correlation between indexes and the Sharpe ratio of individual index. Through our construction of different portfolios, we were able to isolate the impact of different design rules to select indexes portfolio on the overall performance of the portfolios. Further since the benefits of international diversification are quantified from an Australian investor's perspective, the benchmark portfolio in this paper consists of the All Ordinaries alone. Firstly, the results from the portfolio analysis found that majority of the portfolios out performed the benchmark portfolio over the three holding periods, implying that diversification benefits have not been reduced as a result of liberalisation of markets and the Asian Crisis. Secondly the results show that emerging markets do play a valuable part in international portfolios, due primarily to their higher returns and not due to their low correlations with the developed markets. Thus, our portfolio analysis result contradicts the modem portfolio theory. Lastly, a diversification strategy based on investing in the All Ordinaries and the Dow Jones is the only strategy that have consistently outperformed the benchmark portfolio (ie the All Ordinaries alone) over the three holding periods. Further neither the strategy of using ex ante lowest correlation or ex ante largest Sharpe ratio dominates over the three holding periods.