International diversification an Australian perspective : international diversification of Australian equity portfolios into emerging equity markets

Aims of the thesis: The objective of this research is to quantify the returns to an Australian investor from investment in emerging markets and identify the factors that may influence the variation in benefits that accrue to investors diversifying their portfolios in this manner. Scope: The scope of this study is to look at the benefits of investing internationally for Australian investors. The Australian equity market has lower market capitalisation compared with that of many other developed countries and Australian investors can reduce their overall portfolio risk by diversifying into equities from other markets. By investing in the international assets Australian investors expand their investment horizon. Further, by selecting assets that have lower correlations with domestic market assets, investors can increase the expected returns of the portfolio without significantly increasing the risk of the portfolio; and emerging equity markets are one such asset class that provides assets that have lower correlations with Australian assets. The benefits of investing into other markets come from lower correlations with these markets. This study also looks at the changes in correlations over time and tests if the changes in correlations are caused by the changes in the volatilities. Conclusion and contributions: The objective of a portfolio manager is to achieve optimal risk-return combination for his/her portfolio. Emerging markets, because of their different economic structures as compared with the Australian market provide an opportunity for Australian fund managers to include these assets as part of their portfolio. However, the recent crisis in the Asian markets, higher volatility of the emerging markets and changing correlations in equity returns of these markets provide unique challenges for Australian investors. This study makes important theoretical and empirical contributions to existing knowledge. The findings of the study also have significant practical implications for fund managers seeking to exploit the opportunities available through international diversification into emerging markets.This study finds that the correlations of equity returns of emerging markets with Australia change over time and in general have been increasing. Correlations are influenced by the volatility of the emerging markets in most cases and in some cases by relative volatility of the two markets. However, there are still benefits for Australian investors in diversifying into emerging markets and these benefits are expected to continue in the future. This study uses a theoretically superior and computationally efficient model; Asymmetric Dynamic Conditional Correlation Generalised Autoregressive Conditional Heteroskedasticity Model (Asymmetric DCC GARCH model) to estimate these correlations accurately. Accurate assessment of these correlations will assist the manager in better investment decisions and the resulting portfolio will represent the expected benefits of diversifying into these markets more accurately. The study also identifies the specific emerging markets that have lower correlations thus providing better potential benefits, and further finds that the volatility of the emerging markets has an association with the correlations. The results of the study are robust, as numbers of possible portfolios on the efficient frontier were tested. The validity of the results was tested with sensitivity to different risk free rates and different restrictions on proportion of emerging market investment. Limitations: Availability and reliability of data in the emerging market is of concern. This is taken care of in the study by using the stock indexes as the index data is more reliable than individual stocks. Another limitation of the study is the assumption of no transactions cost. To overcome this problem study uses approximate transactions cost based on past studies and results do not change substantially. Study finds that benefits of diversifying into emerging markets for Australian investors are significant even after including transactions costs.