Emerging-Market Equities and Portfolio Diversification

When Risk Reduction Improves Portfolio Efficiency but Lowers Return

Key Findings:

1. Better Ratios Don’t Always Mean Higher Returns

A portfolio’s efficiency ratio can improve simply because risk fell faster than returns. You get a smoother ride, but you end up with less total wealth over time.

2. Emerging Markets Don’t Reliably Cut Risk

Emerging-market equities do not systematically lower portfolio risk. In practice, they often increase total volatility—the ratio improves only because the extra return outweighs the extra risk.

3. How You Measure Risk Can Change the Verdict

Standard metrics treat both big gains and big losses as “risk.” Because emerging markets suffer from sudden, sharp drawdowns, evaluating them strictly on downside risk reveals exposure that traditional metrics miss.

The academic literature finds that investing in emerging-market equities can improve a portfolio’s return–risk ratio because emerging-market returns do not move perfectly with developed-market returns. But a better ratio does not necessarily mean a higher return. It may result from higher return, lower risk or some combination of the two. This paper examines what produces the improvement under two definitions of risk: total volatility, measured by standard deviation, and downside volatility, measured by semivariance.

A better return–risk ratio can arise in three principal ways:

• Return rises while risk falls.

• Return and risk both rise, but return rises proportionately more.

• Return and risk both fall, but risk falls proportionately more.

The third outcome requires particular attention. The portfolio becomes statistically more efficient, but the investor accumulates less wealth. Diversification has successfully reduced risk, but only at the cost of accepting a lower return.

Standard Deviation and Semivariance

Standard deviation measures the dispersion of returns around their average. It treats a return far above the average as just as risky as an equally large return below the average. The Sharpe ratio generally divides the return above a risk-free benchmark by standard deviation.

Semivariance measures only returns below a specified target. The target can be zero, the risk-free rate, the portfolio’s average return or another required return. For example, zero-target semivariance considers only negative returns and gives greater weight to larger losses by squaring each shortfall. Its square root, semideviation, is expressed in the same units as standard deviation. A downside return–risk measure such as the Sortino ratio divides excess return by semideviation rather than by total volatility.

This distinction matters for emerging markets because their returns are often skewed, volatile and subject to unusually severe losses. A portfolio can therefore look attractive when all volatility is counted as risk but less attractive when only harmful volatility is considered.

Evidence Using Standard Deviation

Better Ratio, Lower Return

Min and Kim found that adding international regional indexes provided significant diversification benefits to Korean investors, but that the source and size of those benefits differed substantially across markets. Their results show that adding emerging-market Latin America lowered both the portfolio’s return and its standard deviation while raising the Sharpe ratio from 3.14 to 3.44. The authors concluded that the largest efficiency gains came from emerging-market Latin America and emerging-market Europe.

This is therefore an example of a better return–risk ratio achieved through risk reduction at the cost of a lower return. Note that these results reflect a South Korean won perspective against domestic South Korean benchmarks; exchange-rate dynamics and baseline volatility differ for U.S. dollar investors. Furthermore, the maximum efficiency gains relied on unconstrained optimization with large short positions rather than realistic long-only allocations.

The result should not be interpreted as a practical allocation recommendation. The optimized portfolio contained substantial short positions and an unusually large emerging-market allocation. It demonstrates the nature of the tradeoff, not the likely result of adding a modest emerging-market position to a conventional American portfolio.

Higher Economic Gains Without Consistent Risk Reduction

Bouslama and Ouda found that the economic gains from international diversification remained substantial for American investors and that emerging and frontier markets were major components of their unrestricted optimized portfolios. Their variance-optimized strategy produced greater terminal wealth, a higher Sharpe ratio and slightly lower standard deviation than the U.S.-only benchmark.

However, the authors’ broader conclusion was that unrestricted international diversification did not consistently reduce volatility or minimum loss across the different strategies they tested. Substantial emerging-market exposure primarily enhanced economic gains rather than reliably reducing risk. The authors found clear reductions in return variability and minimum loss only in their restricted portfolios.

The favorable mean-variance result should therefore be treated as strategy-specific. It demonstrates that higher return, lower standard deviation and a better Sharpe ratio can occur together, but it was not the general result across all the portfolio methods examined in the study.

The Min and Kim and Bouslama–Ouda results illustrate why an improved Sharpe ratio cannot be interpreted by itself. In one case, the ratio improved because risk fell more than return. In the other, a particular optimized strategy increased wealth while modestly reducing standard deviation.

Evidence Using Downside Risk

From an investor’s perspective, the relevant risk is generally not volatility itself but the possibility that returns will fall below an acceptable target. Returns above that target are beneficial and ordinarily should not be penalized as risk. Standard deviation remains widely used because it is simple to calculate and produces a tractable portfolio model; it is also a reasonable proxy for downside risk when returns are approximately symmetric.

Emerging-market returns, however, are frequently skewed and non-normal. Stevenson therefore evaluated emerging-market portfolios using lower partial moments, which count only returns below a specified target. He demonstrated that severe negative skewness and high kurtosis, or fat tails, cause standard mean-variance optimization to understate downside exposure, whereas lower partial moments reallocate capital to protect against extreme tail events. He found that this more direct measure of harmful volatility could materially alter portfolio allocations and produce significant performance improvements for risk-averse investors.

Better Downside-Risk Ratio, Lower Return

Bouslama and Ouda found a direct tradeoff between economic gains and downside-risk protection. Reducing emerging- and frontier-market exposure lowered return variability and minimum loss, but it also reduced terminal wealth. At the same time, the semi-variability ratio increased across their optimized strategies when they moved from unrestricted to restricted portfolios.

The authors concluded that unrestricted portfolios were more attractive to investors seeking economic gains, while restricted portfolios were more attractive to investors seeking lower volatility and smaller losses.

This is the central tradeoff examined here. Moderating emerging-market exposure improved downside-risk-adjusted performance, but only by sacrificing some return. Whether that is desirable depends on how highly the investor values protection against losses relative to long-run wealth accumulation.

The comparison is imperfect because the restricted portfolios imposed a 50 percent U.S. allocation and excluded some less-investable markets. It nevertheless provides a direct example of a higher downside return–risk ratio being achieved at the cost of lower accumulated wealth.

Higher Return and Better Ratios, but Higher Risk

Beach examined monthly rebalanced portfolios combining developed- and emerging-market equities. He concluded that “higher returns and higher risk are associated with portfolios that have higher allocations to emerging market equities.” Beach reinforced this using both semideviation and Downside CAPM, or D-CAPM, showing that while total downside risk rose with higher emerging-market exposure, the additional return expanded rapidly enough to improve downside-risk-adjusted ratios.

The Sharpe and reward-to-semideviation ratios nevertheless improved because the additional return more than compensated for the higher standard deviation and semideviation. This was therefore not a risk-reduction result.

What the Studies Establish

Taken together, the studies show that a better return–risk ratio can accompany either higher or lower returns and either higher or lower risk, whether risk is measured by standard deviation or by downside volatility.

The literature therefore does not support a general claim that emerging markets improve portfolio performance by reducing risk. Sometimes risk falls at the cost of return. Sometimes both return and risk rise, but return rises enough to improve the ratio. Under some portfolio methods, return rises while measured risk also falls.

The choice of risk measure can also change the assessment of the same portfolio. A portfolio may appear attractive under standard deviation because upside volatility is treated as risk and included in the denominator. The same portfolio may look less favorable when only returns below a specified target are considered.

Reading List

1. Byoungkyu Min and Tongsuk Kim. “An Examination of International Portfolio Diversification Benefits for Korean Investors.” Journal of Derivatives and Quantitative Studies, Volume 18, Issue 1, 2010. The study examines the diversification benefits of adding developed- and emerging-market regional indexes to Korean equity portfolios.

2. Ons Bouslama and Olfa Ouda. “International Portfolio Diversification Benefits: The Relevance of Emerging Markets.” International Journal of Economics and Finance, Volume 6, Issue 3, 2014. The study compares international portfolios constructed using variance, GARCH variance, conditional value at risk and lower partial moments.

3. Simon Stevenson. “Emerging Markets, Downside Risk and the Asset Allocation Decision.” Emerging Markets Review, Volume 2, Issue 1, 2001, pages 50–66. The study directly compares conventional mean-variance optimization with portfolio construction based on lower partial moments.

4. Steven L. Beach. “Why Emerging Market Equities Belong in a Diversified Investment Portfolio.” The Journal of Investing, Volume 15, Issue 4, Winter 2006, pages 12–18. The study evaluates emerging-market allocations using standard deviation, semideviation, conventional beta and downside beta.