Time-varying Correlations and Optimal Allocation in Emerging Market Equities for Australian Investors

Abstract

Australian investors can reduce their overall portfolio risk by diversifying into equities from other markets. Emerging markets are of interest because of the low correlations with Australian equity market returns. However, several studies have indicated that correlations between equity returns are increasing over time, and using unconditional estimates of correlations in a portfolio optimisation model can result in less than optimal portfolio weights. We use an Asymmetric Dynamic Conditional Correlation GARCH model to estimate time-varying correlations and incorporate these correlation estimates into the portfolio optimisation model. The assets used for portfolio construction comprise seven emerging market indexes that are available for investment to foreign investors. The study finds that, despite increasing correlations, there are still potential benefits in international diversification into emerging markets for Australian investors.