Example Finance Essay

Example Finance Essay
One of the most significant contributions to the investment community has been Markowitz’s modern portfolio theory (MPT) and its foundations in risk return trade-offs and international asset diversification. The growing dependency of Emerging market countries on the US for its stable currency and export sales among other factors has increased their dependence on US markets for their GDP and market growth. This has caused a reduction in the diversification benefits in the Emerging markets. This paper will examine the various empirical evidence on emerging markets diversification and will also construct a portfolio to assess whether investment in these markets still provide benefits.
MPT is based on two key principles of investing, namely that an investor will seek to maximise expected return whilst also minimising risk. Its risk is measured by its standard deviations of returns around expected values. By considering “the expected return of each investment in relation to the impact that it has on the risk of the overall portfolio,” (Litterman (2004) p. 12) An investor can prevent weaknesses in one asset class from reducing the portfolio’s overall return. Therefore a portfolio that is invested in a range of industries or asset classes is more diversified against risks that may affect only one asset class. (Crescenzi (2008) p. 141) The implication is that portfolios are constructed with a rate of return equal to the weighted average rate of return of the holdings and yet its risk will be less than the weighted average return of the portfolio. (Litterman (Ibid) p.14)

Recent developments in Exchange Traded Funds (ETFs) and mutual funds have allowed investors to be invested across a range of markets and countries without being exposed to the potentially large risks of any one internationally traded company. (Crescenzi (Ibid) p.141) More specifically, Index ETF, such as those of iShares, which are designed to closely follow their relevant indices whilst being internationally invested. (Barclays (Ibid) p. 2)

MPT also demands investment in asset classes that correlate as little as possible with each other, as measured by their covariance. In fact, the covariance should be less than one in order to reduce the risk in the portfolio. Asset returns that have covariance equalling one are highly dependent on each other and a covariance of zero means they are independent of each other. Covariance is calculated by multiplying the correlations by the variances of their returns. (Litterman (Ibid) p. 12) A portfolio’s overall risk in relation to its benchmark is measured by its beta. A portfolio with a beta of 1 is has a volatility that is equal to that of its index, whereas a beta greater than one will have greater volatility than the index and is likely to achieve returns greater than the index. It is calculated by dividing a portfolio’s covariance with the index by the index’s variance. (MacKay Shields (2003) p.2)

Mean variance approach

MPT’s mean variance approach demonstrates efficient combinations of high expected returns with a specific level of risk. Any portfolios that exist below the frontier are considered inefficient because they are earning lower returns for the same amount of risk in comparison to those on the frontier. Unfortunately, this is difficult to apply in reality because it requires the use of an optimiser which is based on the calculation of expected returns to arrive at weights. The resulting weights are often considered extreme and inappropriate and the actual calculation of expected returns is also considered difficult to obtain, with the closest and most widely available data being historical returns. Additionally, the approach requires investment in the entire universe of stocks however oftentimes fund managers seek to create portfolios which are invested in a small universe, to attract local investors. (Zimmerman (Ibid) p. 282-262)

Another concern is the models static nature which requires action once the initial allocation of wealth to the securities is made, until the investment horizon is reached. The dynamic nature of stock markets and the wide ranging risks that underline them can greatly impact asset returns, making it crucial for the profitability of an investor to continually rebalance their portfolio according to changes in them.

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