Emerging Market Funds: They May Not Enhance Asset Allocation

Abstract

This article uses portfolio optimization techniques to determine optimal country allocation in an emerging market (EM) portfolio and compares the resulting performance to the performance of the MSCI Emerging Markets Index (MSCI EM Index) to test how large the spread is between the two returns. In addition, the article analyzes optimal allocation of the EM portfolio alongside a developed markets index when using the MSCI EM Index as a proxy as well as a mean-variance EM index as a proxy for EM exposure. The results indicate that popular EM index fund performance and exchange-traded fund (ETF) performance do not align with theory from 1993 to 2017, with a spread in Sharpe ratios from 0.37 to 0.10 between the mean-variance optimized EM performance and the MSCI EM Index. In addition, the optimal weightings are very different, 50 percent when using the mean variance relative to 0 percent. The article concludes that an equal-weighted EM portfolio may be the best choice for an investor, with a maximum allocation of 30 percent to EMs based on an equal-weighted EM portfolio. TOPICS: Emerging markets, exchange-traded funds and applications, performance measurement, portfolio construction