Schumacher says: “I have the following three concerns with respect to investing internationally:
Concern 1 In times of market stress, diversification benefits can be drastically reduced.
Concern 2 Capital in some countries does not flow freely across borders, which can result in increased market segmentation.
Concern 3 Traditional mean-variance analysis may not apply.”
Roth replies: “Your concerns pertain to conditional correlation, market integration and the efficient frontier however they are not all necessarily disadvantages.”
Answer : for concern 3,
The efficient frontier and traditional mean–variance analysis using unconditional correlations would not apply because correlations remain low when returns are high but become high when returns are negative.
Plotting the efficient frontier requires inputs such as the expected returns, covariance, etc. these inputs are assumed to be unconditional. In the case of international investing, the correlations are conditional, in the sense that they can be inconsistent in times of crisis. With this inconsistency over different time periods, the EF could also shift, making the MV optimization analysis less useful.
The above statement implies the existence of conditional correlations on Emerging markets during periods of high volatility. Thus classical models based on historical covariance simply would underestimate volatility during period of market stress.
Say, global financial contagion. In “normal” times, say Country A’s economy is humming because consumers feel wealthier, and Country B – on the other side of the world, is stagnant. Whatever is affecting Country A’s consumers is irrelevant to Country B.
Then, half the banks in Country C fail at the same time. Country A deals with Country C a lot, so its own banks are immediately stressed. Country B does not deal with Country A or C, but the failure of first C’s banks, then A’s banks, throws the entire system into chaos, eventually sending B into the same meltdown and eventual recession.