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International Diversification with Frontier Markets

International Diversification with Frontier Markets. Dave Berger, Kuntara Pukthuanthong and J. Jimmy Yang Seminar at National Taiwan University December 31, 2010. Frontier Markets. Originated in 1990s Small, less accessible, yet still investable countries in the developing world

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International Diversification with Frontier Markets

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  1. International Diversification with Frontier Markets Dave Berger, Kuntara Pukthuanthong and J. Jimmy Yang Seminar at National Taiwan University December 31, 2010

  2. Frontier Markets • Originated in 1990s • Small, less accessible, yet still investable countries in the developing world • Median market cap about US$13 billion in 2009 • May be reclassified as emerging markets

  3. Why frontier markets • New asset class – little research • Low correlation with developed markets (Speidell and Krohne, 2007) • Becoming popular among investment community • S&P index and MSCI index • Mutual funds and exchange-traded-funds emerged • Contribute to international market integration research

  4. Contributions • Study a broad set of frontier market countries with respect to integration and diversification benefits • Analysis of market classification indices details how small and illiquid capital markets tend to behave • Structural breakpoint models identify shifts in world market integration and dynamics surrounding breakpoint • Find evidence that frontier markets offer significant diversification benefits • Mean-variance frontier • Out-of-sample test • Exchange-traded-funds

  5. Major findings • Frontier markets exhibit low levels of world market integration during the sample period • Integration through time varies across countries • Structural breakpoint models identify integration dynamics for each individual country • Given lack of integration, we find evidence of diversification benefits from frontier market equities

  6. Data • Daily return data covering MSCI market classification indices and 25 country-specific frontier market countries • Argentina, Bahrain, Botswana, Bulgaria, Croatia, Estonia, Ghana, Jamaica, Jordan, Kenya, Kuwait, Lebanon, Lithuania, Mauritius, Nigeria, Oman, Pakistan, Romania, Saudi Arabia, Slovenia, Sri Lanka, Trinidad and Tobago, Tunisia, Ukraine, and United Arab Emirates. • US Dollar returns • 1989-2009 sample • Countries added to sample with data availability

  7. Methodology • Pukthuanthong and Roll (2009) principal component regressions • Regress returns on 10 global factors • Coefficient on 1st principal component represents sensitivity to world factor • Adjusted R-square represents proportion of index return explained by global factors • Regression of adjusted R-square on time trend variable measures rate of integration through time

  8. Principal component regressions across indices (1989 – 2009)

  9. Principal component regressions across indices (2008-2009)

  10. Correlations (1989-2009)

  11. Correlations (2008-2009)

  12. Individual country

  13. Rates of integration through time

  14. Rates of integration through time

  15. Country specific rates of integration and structural breakpoint models • Frontier market countries exhibit low levels of integration, and no consistent pattern in integration through time • Estonia displays increasing integration. Botswana, Ghana, Jamaica, Trinidad and Tobago, Tunisia and Ukraine exhibit moderate levels of constant integration • Quandt-Andrews tests indicate significant breakpoints for 15 of the 25 frontier market countries • 2006 for several European countries • 1999-2001 for several African countries • Integration dynamics vary across countries

  16. Structural break tests

  17. Structural breakpoint models

  18. Fitted values from structural break regressions

  19. Sharpe Ratios across portfolios • Portfolios formed across market classification indices with ex-ante information • Augment a U.S., developed and emerging market portfolio with the aggregate frontier market indices • Comparison of Sharpe ratios across portfolios indicates benefits from the inclusion of frontier markets to an already diversified international portfolio

  20. Mean-variance frontier with short sales

  21. Mean-variance frontier without short sales

  22. Out-of-sample Sharpe ratios across portfolios (with short sales)

  23. Exchange-traded-funds (ETFs) • Bekaert and Urias (1996): analyses based on non-investable indexes may overstate diversification benefits • Frontier markets ETFs emerged in June 2008 • Limitation: short investment period • Advantage: naïve investors’ perspective

  24. ETF analysis

  25. Conclusions • Frontier markets exhibit low levels of world market integration • Structural breakpoint models show that levels of integration vary from country to country and through time • Empirical evidence shows that frontier market equities offer diversification benefits • Future studies are needed to understand asset pricing of frontier markets

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