ACCOUNTING & TAXATION ♦ Volume 6♦ Number 1 ♦ 2014

THE RISK-RETURN TRADE-OFF OF INVESTING

IN LATIN AMERICAN EMERGING STOCK MARKETS
Rishma Vedd, California State University, Northridge
Paul Lazarony, California State University, Northridge

ABSTRACT

In this paper we examine risk-return trade-off of investing in Latin American emerging stock markets. In
particular, the study seeks to examine whether equities from Latin American emerging markets might
have offered the Canadian investor high returns for a relatively low level of risk when combined into a
portfolio of Canadian shares. Optimal portfolios were derived based on historic (ex-post) observations
and evaluated utilizing the mean return per unit of risk (MRPUR) performance measure. In particular,
the performance of the MRPUR-optimal emerging market portfolio was compared with the MRPUR of a
portfolio consisting solely of Canadian shares to determine whether any benefits resulted from
diversifying into the emerging stock markets over the ten-year periods. The results revealed substantial
differences in the risk-return characteristics of the MRPUR-optimal portfolios.

JEL: G11, G15

KEY WORDS: Emerging Stock Market, Optimal Portfolio, Risk-Return Characteristics, Equity
Portfolio, Portfolio Diversification

INTRODUCTION

I n this paper, we examine the risk-return trade-off of investing in Latin American emerging stock
markets. In the past decade, Canada’s Foreign Direct Investment in South and Central America grew
almost 6-fold (583%). Canada’s international investment position in 2001 totaled $13.6 billion,
(ECLAC, 2003). International capital markets have seen the gradual removal of restrictions on capital
flows, starting with the developed economies and moving on to the developing economies. This
worldwide trend initiated a degree of international capital mobility, particularly towards emerging market
countries. In particular, this deregulation combined with structural change over the years has resulted in
the development and technological advancement of the Toronto Stock Exchange (TSX), making it one of
the leading capital markets in the world and Canada’s principal market for equity trading. Its market
trading activity, consistent growth and ongoing development increasingly attributed to foreign investors
who, in an effort to diversify their portfolios more effectively, are tapping into foreign capital markets and
buying foreign securities characterizes the TSX. As such, technology and globalization are increasingly
becoming an integral part of the world’s equity and debt markets, especially those in Canada.

De Jong and De Roon (2005), Donadelli and Prosperi (2012), suggest that financial and real market
openness increase, ex-post, expected excess returns in emerging stock markets. In line with Donadelli and
Prosperi (2012), Karadagli (2012) finds that the overall level of globalization significantly improves firm
performance in emerging countries. The emerging markets have become more integrated into the global
financial system (Bekaert, 1995; Bekaert and Harvey, 1995; Harvey, 1995; Barari, 2003; Bekaert et al.,
2003), implying a diminution in the benefits from diversifying into Latin American emerging stock
markets. Most emerging markets have now undergone various degrees of financial liberalization.

As emerging markets grow and develop greater financial and trade links with each other and with
developed markets, they become more correlated; some of the potential gains associated with investment
in emerging stock markets, namely, risk reduction via international diversification are therefore likely to

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fade away. This may reduce the appetite of international investors for emerging market equities.
However, despite the increasing integration of emerging markets with the rest of the world, this does not
imply that the diversification benefits of investing in emerging markets have disappeared; their
correlations with developed markets have remained low (Drummen and Zimmermann, 1992; Speidell and
Sappenfield, 1992). Investing in emerging markets also enables international investors to diversify risk,
thereby achieving more effective insurance than purely domestic arrangements would provide. In
addition, the existence of perceived barriers to investment in these markets restricts the inclusion of
emerging market equities in diversified portfolios, and hence, also limits the integration of these markets
in the global market (Derrabi and Leseure, 2003).

In order to shed more lights on this issue, an investigation into the risk-return trade-off of investment, in
Latin American emerging markets is undertaken in this study. This study provides an analysis on whether
Latin American emerging markets have continued to offer substantial diversification benefits to Canadian
investors despite having become more closely integrated with world financial markets in recent years.
Second, this analysis considers the viability of Latin American emerging market equities as effective tools
for diversification during times of financial crisis, several of which spanned the period of this study. The
Canadian economy can be characterized by its growth, stability, and trade relationships. Rodriguez
(2007) find that in the aggregate, Latin American fund managers demonstrate forecasting ability as
evidenced by a positive and statistically significant attribution return.

The reminder of this paper is organized as follows: The related literature and the scope of this research
study. The research method and methodology are outlined and data are described. Finally the results of
the study and conclusions are presented.

LITERATURE REVIEW

Research into cross-border links in emerging stock markets was boosted by the growth and
increasing openness of these markets, as well as the speed and virulence with which past financial
crises in emerging market economies (EMEs) spread to other countries. Bekaert, Harvey and Ng
(2003) analyze the implications of growing integration with global markets for local returns,
volatility, and cross-country correlations, covering a diverse set of EMEs in, Latin America, in
particular, Chen, Firth and Rui (2002) look at evidence of regional linkages among Latin American
stock markets. This study provides a review of the existing literature regarding the potential benefits of
international portfolio diversification. The case for international diversification is even stronger when
emerging equity markets are included as part of the investor’s investment strategy. Such emerging
markets have been shown to provide investors with excellent opportunities for high returns as well as risk
reduction and risk diversifications in emerging economies can be decreased (Abumustafa, 2007; Jain and
Sehgal, 2013).

Kumar and Thenmozhi (2012) find that the volume does not influence stock returns and volatility
incorporated by market participants in their trading strategies. Global stock markets are more correlated
than ever as international capital markets become more integrated (Longin and Solnik, 1995; De Jong and
De Roon, 2005; Goetzmann et al., 2005; Carrieri et al., 2007; Pukthuanthong and Roll, 2009). Eun et al.
(2008) reveal that benefits from diversified international investments have eroded and thus investors can
benefit from investing in foreign countries. Emerging markets have also attracted attention due to their
high growth and high volatility and the changes in volatility behavior have indeed been induced by
financial liberalization of emerging markets (Cunado [Link] (2009); Dobano (2013). However, although
emerging market returns are more volatile than the returns of their industrialized counterparts, they are
relatively uncorrelated with each other and with developed markets. By holding well-diversified
portfolios, these low return correlations can reduce risk and potentially yield high returns that are not

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available developed markets. Muga and Santamaria (2007) pointed out that momentum strategies yield
profit in the Latin American emerging markets. While a substantial body of research has shown the risk
reduction advantages associated with investing in countries with low returns correlations, the perceived
risks and difficulties of investing in some of these emerging markets is a notable drawback which may
discourage global investors from investing in emerging market equities as much as portfolio theory would
recommend (Errunza and Losq, 1987; Chuhan, 1994). Hence, investor’s portfolios demonstrate strikingly
high weightings towards home country equities. Notably, emerging market returns appear to be driven
primarily by country factors, which provide opportunities for diversification benefits and as such equity
prices, credit and leading rate play a relevant role of investment in emerging market (Peltonen [Link]
(2012).

DATA AND METHODOLOGY

This study examines the risk-return trade-off of investing in Latin American emerging stock markets from
the perspective of a Canadian investor. In particular, optimal portfolios of Latin American emerging
market firms were constructed and compared with portfolios consisting of Canadian shares only. This
analysis was based on historic (ex-post) observations over (i) the whole ten-year period ending 2007 (ii)
each one-year period; (iii) each two-year period; and (iv) each five-year period, based on weekly
observations, to determine whether any potential benefits from diversifying into Latin American
emerging markets existed for Canadian investors. Following the Markowitz framework (1952), these
portfolios were then evaluated using a measure of portfolio performance. In particular, portfolios were
evaluated using the ratio of mean return to standard deviation of return (MRPUR). The mean return of a
portfolio was calculated according to the formula:

𝑅𝑅𝑝𝑝=∑𝑁𝑁 (1)
𝑖𝑖=1 𝑌𝑌𝑖𝑖 𝑅𝑅𝑖𝑖

where Rp is the return on the portfolio, Yi is the proportion of the portfolio invested in share i, and Ri is the
return on share i. Similarly, the standard deviation of a portfolio return was computed according to the
formula:
𝑆𝑆𝑆𝑆𝑆𝑆. 𝐷𝐷𝐷𝐷𝐷𝐷𝜌𝜌= 𝑁𝑁�𝑗𝑗=1 �∑𝑁𝑁 2 2
𝐽𝐽=1 𝑌𝑌 𝑗𝑗𝜎𝜎 𝑗𝑗 + ΣΣ𝑌𝑌𝔧𝔧 𝑌𝑌𝑘𝑘 𝜎𝜎𝑗𝑗𝑗𝑗� (2)
𝑗𝑗 = 1 𝑘𝑘 = 1 𝑘𝑘 ≭ 𝑗𝑗

where [Link] is the standard deviation of the portfolio, Yj and Yk is the proportion of the portfolio
invested in share j and k, σ2j is the variance of share j, and σ2jk is the covariance between shares j and k.

Employing a selective technique, the optimal MRPUR portfolios were identified; the initial portfolio
chosen was the best single firm. Subsequent firms were added to the portfolio, resulting in the highest
MRPUR possible, until all 204 emerging market firms were included in the portfolio. The performance
of the maximum MRPUR portfolio of emerging market equities was then compared against the MRPUR
of a portfolio consisting solely of Canadian shares, as represented by the S&P TSX (Toronto Stock
Exchange) Composite index to determine whether any benefits resulted from diversification into these
emerging market equities over the specific period considered. Specifically, the maximum MRPUR
portfolio is the set of equities, which has achieved the highest MRPUR ratio possible. Consequently, a
set of equities may not be included in the equally weighted maximum MRPUR portfolio. The optimal
MRPUR portfolio is the one, which has achieved the highest value according to the formula:

𝑆𝑆 𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀 𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅 𝑓𝑓𝑜𝑜𝑟𝑟 𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸−𝑊𝑊𝑊𝑊𝑊𝑊𝑊𝑊ℎ𝑡𝑡𝑡𝑡𝑡𝑡 𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃 (𝑆𝑆𝑗𝑗 ) (3)

𝑜𝑜𝑜𝑜𝑜𝑜=
𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆 𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷 𝑜𝑜𝑜𝑜 𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅 𝑓𝑓𝑓𝑓𝑓𝑓 𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸 𝑊𝑊𝑊𝑊𝑊𝑊𝑊𝑊ℎ𝑡𝑡𝑡𝑡𝑡𝑡 𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃 (𝑆𝑆𝑗𝑗 )

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Where Sopt is the equally weighted optimal portfolio based on the set of equities Sj, where j=1,N.

The construction of these overall optimal portfolios reflects the maximum diversification benefits possible
from investing in the Latin American market countries over a particular time period. Specifically, it is
assumed that a risk-averse investor wishes to maximize the portfolio’s expected return while minimizing
the variance of returns. Such a portfolio is considered optimal because it identifies the best risk/return
combination from a financial point of view.

RESULTS AND DISCUSSION

The results from the study confirm the previous findings reported by Sinclair et al. (1997) and Fifield
(1999), which revealed the presence of a very important time factor in explaining the returns of emerging
market shares. More specifically, the results have suggested that there is significant variation in the Latin
American emerging market share returns from one year to the next and from one month to the next. This
strong time effect suggests that fund managers and active investors in Latin American emerging market
countries should be alert to changes in share returns over time and review their portfolios regularly. Thus,
the findings imply that share returns in the Latin American emerging markets considered may be difficult
to forecast.

The analysis conducted in this study has demonstrated that on an ex-post basis, Latin American emerging
market equities offered the Canadian investor excellent opportunities for increasing portfolios returns
while simultaneously reducing portfolio risk. On average, the portfolios comprised of emerging market
firms had a substantially lower standard deviation of return and a higher mean return than the portfolios
made up of Canadian companies. Thus, a portfolio which included Latin American emerging market
shares could have offered the Canadian investor a considerably greater MRPUR ratio than a similar
investment strategy in which the choice was limited to include only Canadian equities in all test periods
examined. The growing linkages of emerging stock markets into the global financial market due to the
relaxation of barriers to entry in emerging markets, increased financial and trade links, improved access to
global information, and globalization in general, have all contributed to an increase in the share return
correlations between this particular grouping of emerging markets and Canada. Yet, the results from the
analysis have shown that diversification efforts which include equities from Latin American emerging
markets have continued to result in sizeable benefits to the international investor even in recent years;
their return correlations have remained sufficiently low to attract global investors despite their integration
into the global financial system.

Furthermore, the construction of various sub-optimal emerging market portfolios displayed reward-to-risk
ratios that were far greater than the optimal reward-to-risk ratios of the Canadian-only portfolios in all test
periods examined, despite the financial crisis and their contagion effects on Latin American financial
markets. Third, in order to reap the full benefits from portfolio diversification, the optimal emerging
market portfolio consisted of at minimum, five companies spread over four Latin American emerging
markets. However, in most test periods over the ten-years, 25 to 29 firms were required to capture the
optimal-MRPUR benefits associated with risk diversification in Latin American emerging market
equities. The results from this analysis are consistent with Poon et al. (1992) and Newbould and Poon
(1993), and contradict the results documented by Evans and Archer (1968) and Wagner and Lau (1971).
The evidence strongly suggested that diversification across country is a much more effective tool for risk
reduction than diversification across industry.

The tables show the risk-return characteristics of the MRPUR-optimal and sub-optimal portfolios over (i)
each one-year sub-period; (ii) each two-year sub-period; (iii) each five-year sub-period and (iv) over the
whole sample period. More specifically, Table 1 details the portfolio mean return, the portfolio standard
deviation of return, and the MRPUR ratio of the optimal portfolio over the various test periods. The

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MRPUR ratio of the optimal portfolio comprised of equities from the Latin American emerging markets
considered is evaluated against the corresponding figure for the MRPUR portfolio comprised of only
Canadian shares to determine whether any potential diversification benefits existed for the Canadian
investor. Table 2 details the size and MRPUR of portfolios that attained 95, 90, 85, 80, 75, 70, 65 and 60
per cent of the MRPUR-optimal emerging markets portfolio in the various test periods in order to
determine the extent to which the portfolios comprised of emerging market shares exceeded the MRPUR-
optimal portfolios comprised of only Canadian shares.

In assessing the risk-return characteristics of the portfolios detailed in Table 1, it is clear that the
performance of the Latin American emerging market MRPUR-optimal portfolios was considerably better
than that of the Canadian-only MRPUR-optimal portfolios in each test period. The Latin American
emerging market portfolio recorded the highest MRPUR-optimal portfolio in the one-year test period,
where a reward-to-risk ratio of 4.2190 was achieved, primarily because of the low standard deviation of
emerging market returns (0.0007). On the other hand, Canadian shares earned a reward-to-risk ratio of
only 0.3908 in the same year; this is the highest MRPUR ratio achieved among all test periods for a
portfolio comprised of Canadian-only equities, albeit, a value almost one-eleventh the size of the reward-
to-risk ratio of its less developed counterpart. More impressively, the MRPUR ratio of the Latin
American emerging market portfolio in the five-year period (0.3000) was a staggering 214 times that of
the Canadian-only portfolio (0.0014). The equities from Latin American emerging markets recorded the
lowest MRPUR-optimal portfolio in period 6 (0.1950), chiefly as a result of a high-risk level (0.0238).
Nevertheless, this ratio compares favorably with the MRPUR ratio of the Canadian-only portfolio (-
0.0047). One final point to note is that the Canadian-only portfolios recorded a negative MRPUR in some
periods. For example, the negative MRPUR ratio of -0.1195 for a portfolio comprised of Canadian-only
securities provided the domestic investor with the lowest reward-to-risk ratio over all test periods; a
portfolio return of -0.0028 was earned in this period.

Table 1: Risk-Return Characteristics of the MRPUR-Optimal Portfolio

Latin America Canada

Period Return [Link] MRPUR Return [Link] MRPUR
1 0.0032 0.0007 4.219 0.0049 0.0126 0.3908
2 0.0021 0.0012 1.647 0.0006 0.0171 -0.0336
3 0.0121 0.015 0.81 0.0021 0.0134 0.1577
4 0.0189 0.0199 0.951 0.0043 0.0126 0.3432
5 0.0100 0.0141 0.7111 0.0021 0.0176 0.1185
6 0.0046 0.0238 0.195 0.0002 0.0329 -0.0047
7 0.0226 0.0159 1.4218 0.005 0.0215 0.2315
8 0.0073 0.0104 0.7068 0.001 0.034 0.0308
9 0.0104 0.0118 0.88 0.0029 0.0274 -0.1044
10 0.002 0.001 1.937 0.0028 0.0235 -0.1195

The table summarizes the risk-return characteristics of the MRPUR-optimal portfolio of Latin American emerging market
Equities in various sub-periods and over the whole sample period. The risk-return characteristics of the Canadian-only MRPUR-optimal
portfolio in each test period are included in the table in order to facilitate a comparison.

In exploring the potential gains from diversification in Latin American emerging markets, the results from
this mean-variance analysis clearly suggest that a portfolio, which included Latin American emerging
market shares, could have offered the Canadian investor a considerably higher MRPUR than a parallel
investment strategy in which the choice was restricted to Canadian equities only.

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Table 2, which highlights the risk-return characteristics of the MRPUR sub-optimal portfolios over
various test periods, confirms the dominance of the Latin American emerging market portfolios over their
developed market counterpart. In particular, the Table 2 displays the size and MRPUR ratio of the
portfolios that attained 95, 90, 85, 80, 75, 70, 65 and 60 per cent of the optimal portfolio value in each test
period. In all cases, the sub-optimal portfolios achieved an MRPUR that was greater than the MRPUR of
the Canadian-only portfolios. For example, even at 60 per cent of the MRPUR-optimal portfolio, the
emerging market portfolio was considerably greater than the optimal portfolio comprised of Canadian
companies in every test period. For instance, over the five years, the MRPUR of the portfolio at this level
was an astounding 129 times that of the Canadian-only portfolio. Clearly, an examination of tables 1 and
2 suggests that investors who diversified their portfolios internationally to include equities from Latin
American emerging market countries would have achieved a significantly greater reward-per-unit-of-risk
than investors who diversified within a single nation, such as Canada.

The results from this analysis therefore support the findings of De Santis (1993), Islam and Rodriguez
(2007), Shachmurove (1998) and Susmel (1998), which are unanimous in their conclusion that
diversification among developing countries in Latin America can yield substantial gains in portfolio
performance. Moreover, although the integration process has increased correlation values between this
particular grouping of emerging markets and Canada, the results from this analysis show that
diversification efforts, which include equities from Latin American emerging markets, have resulted in
sizeable benefits for the international investor in more recent years. The results also reveal the
diversification value of Latin American emerging markets during times of financial crisis.

Table 2: Risk-Return Characteristics of the MRPUR Sub-Optimal Portfolio

Portfolio 100% 95% 90% 85% 80%

Period Size MRPUR Size MRPUR Size MRPUR Size MRPUR Size MRPUR
1 44 4.219 50 4.0081 55 3.7971 81 3.5862 89 3.3752
2 29 1.647 47 1.5647 57 1.4823 64 1.4 8 1.3176
3 14 0.81 26 0.7695 32 0.729 37 0.6885 41 0.648
4 25 0.951 14 0.9035 43 0.8559 50 0.8084 58 0.7608
5 8 0.7111 18 0.6755 31 0.64 36 0.6044 42 0.5689
6 5 0.195 8 0.1853 10 0.1755 12 0.1658 14 0.156
7 37 1.4218 44 1.3507 49 1.2796 54 1.2085 13 1.1374
8 7 0.7068 11 0.6715 17 0.6361 20 0.6008 23 0.5654
9 30 0.88 38 0.836 42 0.792 9 0.748 6 0.704
10 27 1.937 33 1.8402 50 1.7433 18 1.6465 61 1.5496

The majority of the test periods examined required between 25 to 29 emerging market firms to capture the
optimal MRPUR benefits associated with diversification in Latin American emerging market equities.
This is shown graphically in Table 3, which depicts the results of the MRPUR-optimal portfolio for the
whole ten-year sample period. The Table 3 shows that increasing the number of equities in the portfolio
beyond 27 reduces the overall benefits from diversifying into the shares from Latin American emerging
markets. This finding contradicts the widely accepted notion that the benefits of diversification are
virtually exhausted when a portfolio contains approximately 10 shares. For example, Evans and Archer
(1968) concluded that a portfolio consisting of 10 different shares was sufficiently diversified, stating that
the results of their study ‘raise doubts concerning the economic justification of increasing portfolio sizes
beyond 10 or so securities. However, the results reported here are consistent with those of Wagner and

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Lau (1971), Solnik (1974), and Poon et al. (1992), who indicated that there are considerable opportunities
for reducing risk by expanding the portfolio size well beyond 10 shares.

Table 2: Risk-Return Characteristics of the MRPUR Sub-Optimal Portfolio

Portfolio 75% 70% 65% 60%

Period Size MRPUR Size MRPUR Size MRPUR Size MRPUR
1 104 3.1643 115 2.9533 126 2.7424 138 2.5314
2 83 1.2353 94 1.1529 106 1.0706 121 0.9882
3 45 0.6075 50 0.567 2 0.5265 60 0.486
4 67 0.7133 76 0.6657 86 0.6182 97 0.5706
5 48 0.5333 55 0.4978 62 0.4622 71 0.4267
6 16 0.1463 18 0.1365 21 0.1268 24 0.117
7 66 1.0664 74 0.9953 85 0.9242 99 0.8531
8 29 0.5301 35 0.4948 41 0.4594 46 0.4241
9 57 0.66 63 0.616 3 0.572 77 0.528
10 67 1.4528 71 1.3559 77 1.2591 81 1.1622

The table summarises the risk-return characteristics of the Latin American emerging market portfolio.
The table details the size and mean return per unit of risk (MRPUR) of portfolios that attained various percent of the MRPUR-optimal
portfolio in the various test periods.

Furthermore, although Newbould and Poon (1993) do not state a specific number of shares that
constitutes a well-diversified portfolio, they do suggest that the number should be greater than 20. An
analysis of the tables also suggests that companies from some Latin American countries appeared more
often in the optimal MRPUR portfolio than companies from other Latin American countries. This is
confirmed by a chi-squared test of homogeneity, which was performed for each test period. In particular,
this test rejected the homogeneity of frequency of occurrence for the 1-year, 2-year and 5-year sub-
periods.

For example, over the ten one-year sub-periods (p-value of 0.000), Brazilian firms (59) and Chilean firms
(93) were included most frequently in the optimal portfolio, while firms in Argentina (4) and Venezuela
(6) appeared least often. Columbian, Mexican and Peruvian firms appeared 18, 29 and 17 times,
respectively. Similar results were obtained for the five two-year sub-periods (p-value of 0.000) and the
two five-year sub-periods (p-value of 0.000). In particular, firms in Brazil (35) and Chile (45) appeared
quite frequently in the 2-year MRPUR-optimal portfolios, while firms in Argentina (1), Columbia (7),
Mexico (12), Peru (12) and Venezuela (3) appeared less often than average.

Similarly, firms in Brazil (12) and Chile (13) appeared most often in the 5-year MRPUR-optimal
portfolio, while firms in Columbia (3), Mexico (5), Peru (3) and Venezuela (1) appeared less often than
average. In fact, Argentinean firms failed to make a single appearance in the 5-year optimal portfolios.
These results therefore indicate that there is a propensity for firms situated in some Latin American
countries to appear more often in the MRPUR-optimal portfolio than firms from other Latin American
countries. The results from this analysis are consistent with Fifield (1999); Fifield et al., (2001) who
concluded that the inclination of firms in some countries to appear quite frequently in the optimal
portfolio suggests some element of persistence in the country-specific composition of the optimal
portfolio.

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Table 3: Number of Companies That Make Up the MRPUR-Optimal Portfolio in Each One-Year Sub-
Period

Year 1 2 3 4 5 6 7 8 9 10 Total
Country
ARG 2 0 0 0 0 0 0 0 1 1 4
BRA 13 8 2 8 0 1 13 2 7 5 59
CHI 15 14 5 7 3 2 15 3 16 13 93
COL 4 2 1 1 1 1 1 0 3 4 18
MEX 4 4 4 6 3 1 4 2 1 0 29
PER 5 1 0 1 1 0 3 0 2 4 17
VEN 1 0 2 2 0 0 1 0 0 0 6
Total 44 29 14 25 8 5 37 7 30 27 226

The table summarizes the composition of the MRPUR-optimal portfolios in each one-year sub-period. In particular, the table details
the number of companies in each market that are included in the MRPUR-optimal portfolio in each one-year sub-period.

CONCLUSION

This study has tested the risk-return trade-off of investing in Latin American emerging stock markets over
the ten-year period. Optimal portfolios were derived based on historic (ex-post) observations and
evaluated utilizing the mean return per unit of risk (MRPUR) performance measure. In particular, the
performance of the MRPUR-optimal emerging market portfolio was compared with the MRPUR of a
portfolio consisting solely of Canadian shares to determine whether any benefits resulted from
diversifying into the emerging stock markets over the various periods considered. The results revealed
substantial differences in the risk-return characteristics of the MRPUR-optimal portfolios.

On average, the portfolios comprised of emerging market firms had a substantially lower standard
deviation of weekly returns and a higher mean weekly return than the portfolios made up of Canadian
shares; a portfolio which included Latin American emerging market shares could have offered the
Canadian investor a significantly greater MRPUR than a similar investment strategy in which the choice
was limited to include only Canadian equities. This finding is consistent with previous studies which
have concluded that there are benefits to including Latin American emerging market assets in a globally
diversified portfolio in the form of higher portfolio returns and/or a reduction in portfolio risk (De Santis,
1993; Islam and Rodriguez, 1998; Shachmurove, 1998; Susmel, 1998). Impressively, despite the growing
integration of emerging stock markets into the global financial market, the results from this analysis
continue to support the rationale for diversification, even in recent years. Moreover, these markets were
shown to provide diversification value during times of financial crisis when diversification is most
valuable.

This study has followed the mean-variance Markowitz (1952) framework, which assumes normally
distributed data. However, it is necessary to note that one limitation of this study is that the data are, in
fact, not normally distributed. Nonetheless, this study attempts to overcome the non-normality of the data
by using log returns, which more closely follow a normal distribution. Furthermore, the methodology
follows those of previous studies; scholars have acknowledged that emerging market returns deviate from
the standard distributional assumption (Harvey, 1995; Bekaert et al, 1998). In spite of this criticism, they
have used Markowitz methodology. Additionally, even if the data are non-normal, the resulting outcome
from the data in this study will still provide the optimal risk-return trade-off as measured by MRPUR
criteria.

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There is growing conviction amongst the investment community that as both developed and emerging
markets have become more integrated with the rest of the world, the role of industrial effects are playing
an increasingly important role in explaining return variation at the expense of country-specific factors.

Managers interested in investing in the emerging markets of Latin American countries should give great
consideration to their country allocation process; the industry factor appears to play an inferior role as part
of a diversification strategy. This finding is consistent with the results of previous academic studies,
which have also documented the presence of a dominant country component in the share returns of
emerging and developed markets. However, it has been established that ignoring industrial factors will
lead to an important loss of diversification benefits; investors should consider both cross-country and
cross-industry diversification as a way to improve portfolio performance. There is growing conviction
amongst the investment community that as both developed and emerging markets have become more
integrated with the rest of the world, the role of industrial effects are playing an increasingly important
role in explaining return variation at the expense of country-specific factors. However, an examination of
the structure of Latin American emerging market returns over a recent time period has indicated that
country selection, rather than industry selection, is still the more important determinant in explaining the
cross-sectional share return variation in portfolio returns for emerging market investment strategies in the
Latin American region over the decade. However, an examination of the structure of Latin American
emerging market returns over a recent time period has indicated that country selection, rather than
industry selection, is still the more important determinant in explaining the cross-sectional share return
variation in portfolio returns for emerging market investment strategies in the Latin American region over
the decade.

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ACKNOWLEDGMENTS

We would like to thank the journal editors, Terrance Jalbert and Mercedes Jalbert, two anonymous
referees, and participants at the Global Conference on Business and Finance, The Institute for Business
and Finance Research, San Jose, Costa Rica. May 2013.

BIOGRAPHY

Rishma Vedd is Professor of Accounting and Associate Department Chair, Department of Accounting
and Information Systems, California State University, Northridge. Her research appears in journals such
as International Research Journal of Applied Finance, Journal of Education for Business, Journal of
International Business and Economics. She can be reached at California State University, 18111
Nordhoff Street, Northridge, CA 91330-8372. [Link]@[Link]

Paul Lazarony is Professor of Information Systems and Department Chair, Department of Accounting and
Information Systems, California State University, Northridge. His research appears in journals such as
Journal of Business and Economices Research, Journal of Services and Standards, and Journal of
College Teaching and Learning. He can be reached at California State University, 18111 Nordhoff
Street, Northridge, CA 91330-8372. [Link]@[Link]

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