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U.S. investors who might primarily invest in NYSE or Nasdaq stocks, perhaps through SPDR S&P 500 Trust ETF (NYSEARCA:SPY), can capture some diversification benefits from emerging markets. Furthermore, investors in other countries that are highly correlated to the U.S. can also capture these benefits, but to differing degrees. Most likely, the broad based emerging market ETFs, like iShares MSCI Emerging Markets Index Fund (NYSEARCA:EEM), will show consistent correlations between highly correlated developed market ETFs. For this article, I'll compare a set of developed market ETFs to a set of emerging market ETFs. The developed market ETFs are:

Developed Market ETFs

Ticker Name Assets ($ Billions) Region
SPY SPDR S&P 500 Trust ETF 92.09 North America
EWC iShares MSCI Canada ETF 5.71 North America
EWJ iShares MSCI Japan Index ETF 7.18 Asia
EWG iShares MSCI Germany Index ETF 3.8 Europe
EWU iShares MSCI United Kingdom ETF 1.33 Europe

Source: Yahoo!Finance for assets downloaded July 15, 2011.

The emerging market ETFs are listed in the following table:

Emerging Market ETFs

Ticker Name Assets ($Billion) Region
EEM iShares MSCI Emerging Markets Index Fund 38.41 Global
VWO Vanguard Emerging Markets ETF (NYSEARCA:VWO) 64.17 Global
EWX SPDR S&P Emerging Markets Small Cap ETF 0.61 Global
EZA iShares MSCI South Africa Index 0.60 Africa
AFK Market Vectors Africa Index ETF 0.12 Africa
EWT iShares MSCI Taiwan Index Fund 3.45 Asia
EWY iShares MSCI South Korea Index 4.92 Asia
EWH iShares MSCI Hong Kong Index 2.12 Asia
EPP iShares MSCI Pacific ex-Japan Index Fund 3.97 Asia
EWS iShares MSCI Singapore Index 1.87 Asia
EWM iShares MSCI Malaysia Index Fund 1.00 Asia
THD iShares MSCI Thailand Investable Market Index Fund 0.58 Asia
VNM Market Vectors Vietnam ETF 0.31 Asia
FXI iShares FTSE/Xinhua China 25 Index Fund 7.03 China
PGJ Powershares Golden Dragon Halter USX China Portfolio Fund 0.41 China
GUR SPDR S&P Emerging Europe ETF 0.28 Emerging Europe
RSX Market Vectors Russia ETF 3.91 Emerging Europe
CEE Central Europe and Russia Fund, Inc. (The) 0.58 Emerging Europe
GUR SPDR S&P Emerging Europe ETF 0.28 Emerging Europe
PLND Market Vectors Poland ETF 0.08 Emerging Europe
ESR iShares MSCI Emerg Mkts Eastern Europe Index 0.04 Emerging Europe
IIF Morgan Stanley India Investment Fund, Inc. 0.48 India
PIN PowerShares India 0.52 India
ILF iShares S&P Latin America 40 Index Fund 2.31 Latin America
EWW iShares MSCI Mexico Investable Mkt Idx 1.60 Latin America
GXG Global X/InterBolsa FTSE Colombia 20 ETF 0.20 Latin America
EPU iShares MSCI All Peru Capped Index 0.45 Latin America
ECH iShares MSCI Chile Investable Market Index 0.86 Latin America
EWZS MSCI Brazil Small Cap Index Fund 0.06 Latin America
TUR iShares MSCI Turkey Investable Market Index Fund 0.58 Middle East/Europe
EGPT Market Vectors Egypt Index ETF 0.07 Middle East/Africa
GAF SPDR S&P Emerging Middle East & Africa ETF (NYSEARCA:GAF)

0.14 Middle East/Africa

Source: Yahoo!Finance for assets downloaded July 12, 2011. There are some other interesting ETF options including EIDO for Indonesia and RSXJ for small caps in Russia; however, there is still insufficient history. Some other ETFs, like AFK and EGPT also have limited histories. This list is not exhaustive and does not include many new emerging market sector specific ETFs.

Negative Correlation offers the Best Diversification

The above list was assembled to provide a good mix of ETFs from different regions. The next part of the analysis is to compute correlations to the various developed market ETFs to determine which ones have the lowest correlation. Correlations range from -100% to 100%. A correlation of negative 100% offers the best diversification benefits in terms of reducing portfolio volatility. A correlation value of 100% offers no diversification benefit. Very few securities offer negative correlations. The following table shows the 24 month correlations for the ETF list by developed market ETFs. I also included three emerging market ETFs for comparison.

24 Month Correlations

Ticker SPY EWJ EWU EWC EWG EWZ FXI PGJ THD
EWZ 79% 32% 77% 81% 75% 100% 79% 80% 67%
FXI 61% 3% 58% 64% 67% 79% 100% 83% 53%
PGJ 78% 31% 69% 82% 80% 80% 83% 100% 58%
EPP 91% 52% 90% 84% 87% 93% 72% 82% 70%
EWW 88% 52% 75% 80% 81% 80% 73% 79% 56%
ILF 83% 38% 80% 84% 79% 99% 79% 83% 68%
VWO 83% 38% 81% 82% 83% 94% 79% 85% 74%
EEM 83% 36% 80% 83% 82% 94% 79% 85% 73%
GUR 82% 52% 89% 71% 84% 78% 57% 69% 58%
AFK 80% 58% 83% 73% 70% 77% 59% 62% 63%
RSX 80% 50% 79% 78% 73% 81% 53% 65% 51%
EZA 80% 53% 81% 76% 74% 80% 59% 63% 72%
GAF 77% 54% 78% 73% 68% 78% 56% 60% 72%
CEE 76% 47% 79% 63% 79% 73% 50% 61% 60%
EWT 75% 42% 74% 73% 75% 78% 58% 73% 59%
EWS 73% 27% 71% 70% 75% 80% 72% 86% 60%
EWX 72% 33% 73% 72% 75% 88% 75% 81% 76%
EWY 71% 35% 66% 68% 71% 74% 54% 70% 66%
EWH 62% 22% 61% 66% 66% 78% 85% 84% 60%
EWM 55% 26% 64% 51% 58% 72% 63% 59% 56%
EPU 55% 23% 45% 63% 41% 62% 57% 58% 56%
IIF 53% 12% 51% 60% 56% 80% 71% 71% 71%
PIN 53% 17% 46% 58% 58% 73% 61% 63% 75%
TUR 51% 36% 60% 35% 59% 46% 32% 45% 57%
THD 48% 23% 52% 61% 53% 67% 53% 58% 100%
GXG 41% 14% 53% 42% 50% 58% 38% 53% 57%
ECH 28% 8% 39% 32% 31% 51% 35% 47% 54%
Average 69% 34% 69% 68% 69% 78% 65% 71% 65%
Source: Calculated from returns from monthly split and dividend adjusted prices from Yahoo!Finance.

The first observation is that different developed markets have somewhat different correlations with emerging markets. The most drastic differences are seen between EWJ (Japan) and the other reviewed developed markets. For Japanese investors who primarily invest at home, the diversification benefits of investing in emerging markets could be significant. China (NYSEARCA:FXI), India (IIF, PIN), Chile (NYSEARCA:ECH) and Thailand (NYSEARCA:THD) show almost no correlation to EWJ. Furthermore, investors in emerging markets might benefit from investing in other emerging markets. EWZ, FXI and PGJ all have lower correlations to TUR than SPY, EWU and EWG, which is probably just due to the fact that Turkey is linked into the European economy. Another interesting observation is that EWJ is not very correlated to the rest of Asia. In fact, right now EWJ is less correlated to SPY than EWZ.

Japanese investors may be able to benefit more than Brazilian investors

The first key point is that this concept of diversification only applies if you are primarily invested in your home market or other similar markets. An investor holding a highly diversified global portfolio has already captured these benefits. If everyone the world over spread their equity investments around, we would all hold a global stock portfolio and each market would offer all investors the same incremental diversification benefits. However, this is not true. Home market bias is the primary investing regime and the Japanese, among more developed markets, in particular are missing out on a good opportunity.

However, it is quite possible that emerging market investors can also gain from diversifying across other emerging markets. In fact, THD and FXI had lower average correlations across emerging markets than all the developed market ETFs reviewed (except EWJ). Unfortunately, Brazilian investors might have the worst time diversifying-- given the high average correlation and also the fact that EWZ is pretty correlated to developing markets as well. It should be noted that Brazilians might gain a benefit from diversifying with other developed market ETFs than the ones considered in this article; however, EWZ showed higher correlations to SPY, EWC, EWG and EWU than EWJ showed to those same ETFs.

Disclosure: I am long SPY, EWZ, EWH, FXI.

Additional disclosure: Disclaimer: This article is for informational and educational purposes only and shall not be construed to constitute investment advice. Nothing contained herein shall constitute a solicitation, recommendation or endorsement to buy or sell any security.

Source: Emerging Market Diversification Benefit Depends on Investor's Home Country