Is There a Free Lunch in Emerging Market Equities?

Abstract

Several studies have characterized investments in emerging markets as a ‘free lunch,’ arguing that there are significant diversification benefits for globally minded investors. The conclusions reached by emerging market proponents depend critically on an investor's ability to achieve the performance of the market indexes used in the calculation of means and correlations. The authors argue that a more realistic picture of the true diversification benefits from emerging equity markets is available from three investment vehicles the provide access to emerging market returns, while circumventing many of the restrictions and costs that limit the conclusion of previous emerging market research. For these three in vestment vehicles-closed-end mutual funds, open-end mutual funds, and ADRs-the authors find, based on mean-variance spanning tests, that diversification benefits from emerging equity markets are sensitive to the particular investment vehicle. The authors discuss the implications for diversification benefits as equity markets in emerging economies mature.