Time-varying correlations and optimal allocation in emerging market equities for Australian investors : a study using East European depository receipts

The Australian stock market has lower market capitalization compared to that of many other developed countries and Australian investors can reduce their overall portfolio risk by diversifying into equities from other markets. Choosing stock markets with low correlations with the domestic market can increase the portfolio diversification benefits. For Australian investors, the East European stock markets are one such asset class. In this paper we study the diversification benefits to Australian investors from diversifying into the East European equities. Several studies indicate that correlations between asset returns are time-varying and using unconditional estimates of correlations in a portfolio optimization model can result in misallocation of assets. For this study, multivariate Generalized Autoregressive Conditional Heteroskedasticity (GARCH) models are used to estimate time varying correlations to alleviate this problem. The assets used in this portfolio optimization model comprise of American Depositary Receipts (ADRs) of 11 Russian, 5 Polish, 2 Hungarian and 1 Czech Republic equities and All Ordinaries Australian Index. Ex-post return calculations show that unrestricted portfolios ofAustralian Index with the ADRs outperform the Australian only returns. With investments restricted to 10% in ADRs we do not find statistically significant diversification benefits but as we increase the restriction to 20% we do find statistically significant diversification benefits.