A research report on the global equity markets states that a composite of developed equity markets have historically produced a nominal return of 9% p.a. with an annualized standard deviation of 20%, while a similar composite of emerging market (EM) equities has nominally returned 11%, but with an annualized standard deviation of 30%. The long-term correlation between these two composites has been 60%, while the risk free rate has been 3%.

(i) Despite this relatively high positive correlation between the developed and EM equity markets, the research report states an investor would have earned a superior risk-adjusted return over the historical period if they had maintained a portfolio with an 80% weighting in the developed market composite and a 20% weighting in the EM composite. Assuming no transactions costs, are they correct? Explain your answer.

(ii) While you expect most of these risk and return statistics to persist in the future, you believe the EM composite will return 12% p.a. over the coming years. As a result, you decide to construct a portfolio comprised of 40% in the EM composite and 60% in the developed markets composite. Is your idea sound? Why or why not?

Answer rating: 100% (QA)

i The investor would have earned a superior riskadjusted return over the historical period by maintaining a portfolio with an 80 weighting in the deve... View the full answer