Should investors add emerging market equities to a portfolio that is already diversified among the G7 market equities

Over the past decade, the rapid growth in emerging stock market capitalization has exceeded that of the developed markets (Standard & Poor Fact Book, 2000). Despite this increased growth, the proportion of investments in emerging markets continues to be very small in comparison to the total investment funds available (Errunza, 1994).;The objective of this dissertation is to study the desirability of including emerging market equities in a portfolio that is already diversified among G7 market equities. The arguments for including emerging market equities in a globally diversified portfolio are first reviewed. The findings suggest that risk can be further reduced while achieving the same or even a higher expected return. Secondly, a sample of monthly dollar denominated stock returns data that covers 28 emerging and the G7 stock markets for the period 1992 to 2003 were selected for this study. All the data were obtained from the Morgan Stanley Capital International (MSCI) data set. Thirdly, the E-View software package was used to analyze the time series characteristics of the data. The results indicated that the correlation between the emerging and G7 stock returns overall are small and negative, except for the correlation between the US and the emerging markets.;Finally, the Markowitz mean-variance model was applied to the stock returns data using quadratic programming in identifying the potential gains accruing from an international portfolio that included emerging market equities. The findings indicated that the rate of return in combined optimal portfolios is higher than the returns from a diversified G7 market portfolio. The level of risk associated with these returns was less, or similar in some cases, to the G7 equity portfolio. The Britten-Jones (1999) statistical inference procedures were then used to examine the magnitude and effect of sampling error in estimates of the composition of the efficient international equity portfolio. The results indicated that none of the zero-weight restrictions can be rejected at the 0.05 level of significance.