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Authors Asani Sarkar and Kai Li show that investing in emerging market stocks can bring substantial benefits even in the face of restrictions on short selling.
The starting point of the analysis is the "home bias puzzle"-the tendency of U.S. investors to shun foreign stocks despite persuasive evidence that the addition of foreign stocks can strengthen a portfolio. The authors suggest that the home bias of U.S. investors may stem from a belief that restrictions on stock trading in foreign markets largely negate the gains from international diversification.
To determine whether such restrictions can undo the gains from diversification, Sarkar and Li examined the effect of one type of restriction, that on short sales. Using data on stock returns in fifteen G7 and emerging market countries over the 1976-99 period, they looked at the performance of international portfolios under alternative assumptions: first, that trading was unrestricted, and second, that a ban on short sales was in place.
Under unrestricted trading, diversified portfolios that included emerging market stocks provided a substantial increase in risk-adjusted returns-as well as a large reduction in risk-relative to a purely domestic portfolio. Although a ban on short sales in emerging market countries reduced these benefits slightly, the gain in returns and reduction in risk remained sizable. By contrast, portfolios whose foreign holdings were limited to G7 stocks showed only a small gain in returns under unrestricted trading, and no additional return when short sales were prohibited in both developed and emerging market countries.
These findings lead the authors to conclude that, for the period under review, emerging markets remained a valuable investment opportunity for U.S. investors even when short sales were prohibited.
Sarkar and Li further tested this conclusion by comparing their findings for the 1976-89 period and the 1990-99 period. Although the argument is often made that the global integration of markets in the 1990s sharply reduced the benefits of diversification, the authors find that holding emerging market stocks continued to provide an appreciable gain in returns in the 1990-99 period, with or without restrictions on short sales.
Asani Sarkar is an economist in the capital markets group at the New York Fed, and Kai Li is assistant professor of finance at the University of British Colombia.