Portfolio Diversification and Risk Reduction: Evidence from Emerging Stock Markets

Abstract

This research investigates the efficacy of asset allocation in reducing risk across the major emerging equity markets of China (SSE Composite), India (NSE NIFTY 50), Brazil (Bovespa), South Africa (JSE All Share), Pakistan (KSE-100), Indonesia (IDX Composite), and Turkey (BIST-100). Seven years of daily data (2015-2024) from 2,519 observations for each country were analyzed using a plethora of econometric techniques. These techniques included Johansen’s cointegration, DCC-GARCH(1,1), mean-variance optimization, and panel GMM regression methods. The Sharpe Portfolio achieved a value of 0.921 in contrast to the MSCI Emerging Markets, which achieved a value of 0.625, a 47.4% improvement. DCC-GARCH showed mean correlations that increased, on average, by 32.6% during the COVID-19 crisis period and exhibited a trend of sub-par mean-reversion. Three major cointegration relationships showed no complete integration of the markets, allowing for significant diversification. The KSE-100 had the lowest average cross-market correlation (ρ̄ = 0.183), allowing it the greatest potential for diversification. Panel GMM estimates showed that a standard deviation increase in the diversification index improved risk-adjusted returns by 39.4 basis points. The results obtained are useful for the management of assets and sovereign wealth funds and for the policies to be utilized for emerging markets.