Time-Varying Correlations and Optimal Allocation in Emerging Market Equities for Australian Investors: A Study Using East European Depositary Receipts

Australian stock market has lower market capitalization compared to that of many other OECD countries and Australian investors can reduce their overall portfolio risk by diversifying into equities from other markets. Choosing stock markets with low correlations with the domestic market can increase the portfolio diversification benefits. For Australian investors, East European stock markets are one such asset class and this paper studies the diversification benefits to Australian investors from diversifying into the East European equities. Since the correlations between asset returns are time-varying, using unconditional estimates of correlations in a portfolio optimization model can result in misallocation of assets. To alleviate this problem, this study uses multivariate GARCH (Generalized Autoregressive Conditional Heteroskedasticity) models to estimate time varying correlations. The assets used in the portfolio optimization model for this study comprise of American Depositary Receipts (ADRs), 11 Russian, 5 Polish, 2 Hungarian and 1 Czech Republic equities and All Ordinaries Australian index. Ex-post return calculations show that unrestricted portfolios of Australian index with the ADRs outperform the returns from holding only Australian stocks. With investments restricted to 10% in ADRs there is no statistically significant diversification benefits but with 20% investment in ADRs there is evidence of statistically significant diversification benefits.