Looking at New Markets for International Diversification: A Frontier Markets Perspective for Australian and US Investors

Investors and academics around the world are intrigued by new possibilities to reduce risk and increase the returns of portfolios. The portfolio theory suggests that diversifying to include assets from different industries and various markets will reduce a substantial part of the total risk of the portfolio and hence bring gains to the investor. Ever since the portfolio theory was developed in 1952 by Markowitz, there have been various improvements of it, and the central argument that the inclusion of diverse assets in a portfolio is beneficial to the investor has stayed afloat. However, whether or not the assets are diverse enough to bring about significant gains has become the primary area of examination. In the early years of diversification studies, international diversification across developed markets was found to be profitable. As the advanced capital markets increasingly became integrated with each other, these gains diminished. Investors, in their search for better avenues for diversification, identified emerging markets as a new asset during the 1990s, and they achieved unprecedented benefits from diversifying into them. Globalisation and the financial integration of markets since then have resulted in a decline in benefits from emerging market diversification in the recent years. This investment scenario has set the premise for venturing into the less researched area of frontier market diversification. The primary objective of this thesis is to examine whether there are significant benefits for a developed market investor from frontier market diversification. Frontier markets are the smaller and less developed markets among the developing economies that are not large enough to be included in the emerging v markets category. There are around 60 frontier markets around the world and these have been recently opened to international investors and are theoretically highly segmented from the developed capital markets. This study analyses whether the potential benefits from frontier market diversification differ for a small developed market (Australia) compared to that of a large developed market (the U.S.A). The importance of looking into the Australian perspective of frontier market diversification stems from the facts that the Australian market is distinct enough to hedge major effects during a crisis such as the GFC; and also because of the investment environment in Australia that is witnessing a tremendous growth in managed funds. There is no previous research that has compared the diversification benefits from frontier markets for Australian and US investors. This thesis will bridge these significant gaps in the existing literature. The findings of this study provide a significant contribution to the literature. The study finds that frontier market diversification is beneficial to both groups of developed market investors that are analysed. But the benefits for the US investor are much larger than that for the Australian counterpart. One of the major contributions of this thesis is the out-of-sample analysis; the results from the holding out period test also emphasise on the vast disparity in diversification benefits accruing to the two investors in consideration. The findings of this study are robust; a statistically advanced and computationally efficient model, AG-DCC GARCH, has been employed to estimate the time varying correlations between the markets. The ex-post analysis enhances the significance of the results vi presented. The results from this thesis will provide the investors the confidence to consider frontier markets as potential additions to their portfolio, and will also generate further research interest in the area.