Do emerging and frontier markets diversify?
The authors of a new study say ‘not that much’, but reading their study, my answer remains ‘yes’.
What caught my eye about this study is that they do not just look at the simple correlation between 13 developed, 13 emerging, and 13 frontier markets over different time horizons. Instead, they used a wavelet analysis of each market to identify the underlying market cycles and then calculated how correlations change if the investment horizon of the investors increases from one day to two years.
Wavelet analysis is a concept taken from electrical engineering that I have used myself in the past because it is a very straightforward way to isolate cycles in noisy data. Importantly, they isolate cycles without having to use the filters economists use, which tend to be unreliable where you need them the most, namely at the present moment.
If you are interested in wavelet analysis, feel free to read up on it in this book, but be prepared to be overwhelmed if you are not an engineer. Indeed, the reason why I no longer use wavelet analysis in my work is that I tried to introduce a simplified version (see here) in my workflow twice in my career. Both times, my colleagues and clients looked at me in total confusion. So, I have abandoned these methods since it is of no use to me to have a model that none of my clients understands and as a result has zero impact. Note that this is not a criticism of my colleagues or clients. It is just an observation that professional investors tend not to be trained mathematicians or engineers.
Anyhow, the study on the diversification benefits of emerging and frontier markets shows that correlations and covariance with developed markets increase as the time horizon of the investor increases. This isn’t a surprise, since developed markets, especially the US and the US dollar, drive the global economy and thus will influence emerging and frontier markets over time.
Where I tense up is when the authors of the study write in their summary that “the associated long-run diversification potential of these markets is found to be much smaller than previously established”.
That may be the case, but look at the optimal allocation to developed markets (G13), emerging markets (E13) and Frontier markets (F13) for minimum variance portfolios below. The chart shows the average allocation to these markets among all combinations of developed markets diversified with emerging and frontier markets and a range of investment horizons.
Composition of minimum variance portfolios
Source: Conlon et al. (2025)
Yes, the optimal allocation to emerging and frontier markets declines as the investment horizon grows. That is true not just for minimum variance portfolios but also for other portfolios along the efficient frontier. But even for the longest investment horizon tested (which admittedly is still a short two years), the allocation to emerging and frontier markets remains substantial. Typically, we are talking about an allocation of 20% or more for a minimum variance portfolio, which is much higher than what most investors are used to.
As a practitioner, then, I read this study and think that even with my 10-15% allocation to emerging markets, I am probably still underinvested.