Dynamics of effective portfolio diversification among EFA markets: a heterogeneous panel analysis

This paper focuses on the role of various factors of international co-movement patterns among equity returns of frontier and emerging markets. This study originated from Markowitz portfolio theory (1952) after which Grubel (1968) applied his concepts of diversification. This study fills the previous gaps by providing information about role that various factors have on international stock market co-movement rather than relying only on the return correlation. We constructed an international co-movement index through rolling beta estimation method followed by the estimation of bilateral market and economic variables. In the end, we applied panel data analysis to find level of variance that these included markets, financial and macro-economic variables have on stock market co-movement. Results highlight significant role of market size differential and macro-economic variables in explaining return co-movement of Pakistan with rest of the countries. Significance of our macro-economic factors are in accordance with portfolio balance theory presented by Kodres and Pritsker (2002) stating that investors possess information about macro-economic variables thereby readjusting their portfolios for effective diversification.