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When the Federal Reserve Board hikes interest rates investors should consider diversifying with stocks from emerging nations.
Using 24 years of data from markets in 20 nations, three researchers found that diversifying stock portfolios with equities from emerging nations adds from 1.5 percent to two percent to returns.
"A more surprising result, however, is that the benefit of investing in emerging market stocks accrues almost entirely during times of restrictive U.S. monetary policy," says Dr. C. Mitchell Conover, professor of finance at the University of Richmond in Virginia.
During periods when the Federal Reserve was raising interest rates, adding emerging nation equities added more than 4 percent per year to the average portfolio's performance.
When the Fed was lowering interest rates, however, equities from emerging markets add only a "trivial" return to the stock portfolio-about 0.2 percent annually, the researchers found.
The paper, "Are There Benefits to Investing in Emerging Markets?," has been accepted for publication later this year by the Financial Analysts Journal. In addition to Conover, the researchers include Gerald R. Jensen of Northern Illinois University and Robert R. Johnson, senior vice president of the Association for Investment Management and Research.
Creating a variety of hypothetical investment portfolios with varying levels of risk and using data from 1976 through 1999, the researchers found that "emerging markets serve to hedge the poor performance generally exhibited by developed country equities during periods of restrictive monetary policy."
Theirs is one of the most comprehensive studies of the impact of equities from emerging nations such as India, Brazil, Nigeria, Mexico, Zimbabwe, Chile, Venezuela, the Philippines, Maylasia and Turkey on the performance of stock portfolios primarily weighted with U.S. equities. They used three composite indices to build their portfolios including one that measures emerging markets.
"We find that for the past 24 years, U.S. investors could have improved performance substantially by investing in emerging market equities during restrictive U.S. monetary periods," says Conover.
"By supplementing developed market equities with emerging market equities during restrictive periods, U.S. investors could have expanded the set of available efficient portfolios and added approximately 4.5 percent per year in returns."
Why do emerging nation equities aid portfolio performance when U.S. money is tight? The researchers found a strong link between restrictive U.S. monetary policy and poor performance of developed country stock markets. But they did not find the same link when they examined the monetary policies and equity performance of emerging nations.
"The monetary authorities in developed markets may coordinate their policies more closely than do the monetary authorities in emerging markets," Conover suggests.
The researchers believe that U.S. monetary policy should play a major role in determining the allocation of resources into international equities.
If you would like to see a copy of their paper, please let me know and I'll send it to you. If you would like to speak with Dr. Conover, please call him at 804-287-1921. His e-mail address is [email protected].
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