Do Short-Selling and Margin Trading Impact the Replication of Emerging Market Indexes?

Abstract

The diversification benefits of investing in emerging equity markets are reported to be declining as emerging and developed markets become more correlated. Yet U.S. traded securities can be used to replicate emerging market indexes if margin trading and short sales are allowed (but not if short sales are prohibited). In other words, hedge fund managers who can trade on margin and sell short can obtain the benefits of investing in emerging market assets by forming portfolios of U.S. traded securities. If investment managers are prohibited by law or by policy from engaging in margin trading or short sales, emerging market assets are unique and cannot be replicated using U.S. traded securities.