An article co-authored by Barney School of Business Professors Bharat Kolluri (Economics), Susan Wahab (Accounting), and Mahmoud Wahab (Finance), “Systematic Covariations and Emerging Asian Equity Markets Diversification Benefits to U.S. Equity Investors,” has been accepted for publication in the Review of Pacific Basin Financial Markets and Policies.
Abstract: Unconditional and conditional correlations have played a central role in portfolio analysis, optimization and performance measurement. However, recent studies show these two correlation measures are inappropriate for measuring both financial integration, and, therefore, diversification benefits. We use an alternative correlation measure we refer to by factor model-implied correlation estimated from the systematic (predictable) portion of returns of a multi factor model with several global risk factors. Estimated implied correlations, co-variances, variances, and in-sample (predicted) mean returns are used to calculate optimal U.S. and Asian equities asset allocation weights in alternative Global equity portfolios varying by Asian equity market combined with U.S. equities, as well as by whether: (i) implied or unconditional statistics are used, and (ii) portfolios are optimized by Sharpe ratio-maximization or variance-minimization. Risk-adjusted returns of alternative actively-managed Global equity portfolios are compared to U.S. equities risk-adjusted returns. We find Global equity portfolios with asset allocation weights calculated using factor model-implied statistics uniformly yield higher risk-adjusted returns than U.S. equities and Global equity portfolios with asset allocation weights calculated using unconditional portfolio statistics. In actively-managed Global equity portfolios with asset allocation weights calculated using implied statistics, India and Taiwan consistently rank as top contributors, while South Korea, Singapore, and Hong Kong consistently rank as bottom contributors to enhancing U.S. equities risk adjusted returns. While our analyses are dynamic, they use implied portfolio statistics estimated from historical returns distributions. Future studies can extend this research using conditional (out-of-sample) ex-ante estimates of systematic returns, co-variances, variances, and correlations in examining emerging markets contributions to developed markets equities.