This paper: (i) examines the potential benefits from diversifying into eight stock markets of Central and Eastern Europe (CEE); and (ii) quantifies the importance of country, industry and time factors in CEE equity returns. The findings suggest that substantial benefits exist from investing in CEE stock markets and that they accrue more from the geographical spread than from the industrial mix of the equities included in the portfolio. However, the returns earned by CEE equities vary dramatically over time. This variability may hamper the efforts of investors attempting to exploit the diversification “free lunch”.
Recent years have seen a tremendous increase in the volume of foreign portfolio flows to emerging stock markets (ESMs). These increased investment flows appear to have been stimulated by the reported opportunity for higher returns and reduced portfolio risk (Divecha et al., 1992 and Eaker et al., 2000). As a result, financial institutions have begun to offer numerous global emerging market investment funds in addition to specialised Asian and Latin American investment vehicles which focus on a specific region.1 However, more recently, a number of specialised European emerging market funds have been established; these funds have recorded exceptional results. For example, in 2003, eight of the top ten performing emerging market funds had a European focus (Financial Times, 2003). Furthermore, the top ranking fund, Pictet Fund Eastern Europe, earned a total return over the three-year period, 2001–2003, of 70.6 percent.2
Most of the previous research which has investigated the performance of emerging markets has adopted either a global focus or employed a regional perspective by considering the emerging markets of Asia and Latin America. By contrast, this paper examines the emerging markets of Central and Eastern Europe (CEE)—a group that to date has not been analysed to any great extent in academic studies. The objectives of this paper are to: (i) investigate the theoretical benefits available from investing in emerging markets by examining the historical returns earned by equities from a number of countries located in the CEE region over the recent period 1998–2003; and (ii) quantify the role of country, industry and time effects in driving the returns of individual CEE emerging market shares. The results of this analysis have important implications for the management of CEE investment portfolios. Specifically, they determine the size and nature of the gains from diversifying into the CEE region and indicate how the research function of institutions engaged in CEE equity investment should be managed.
This research has a number of novel features. First, while most studies which examine the performance of ESMs focus on aggregate national indices, this study employs disaggregated data. Thus, a measure of realism is injected into the analysis by allowing portfolios of equities of individual companies from different markets to be constructed. Second, the study analyses a mix of different markets from the CEE region which vary in terms of size, industrial composition, spread of securities traded and technological sophistication; previous research has tended to concentrate on the larger markets in this region. Third, the study examines the gains from diversifying into the CEE region for a recent time period, January 1998 to December 2003.3 Finally, to date, no study has investigated the nature of the gains from diversifying into CEE equity markets. This study attempts to fill this gap.
In order to establish a background for the analysis, Section 2 presents a brief review of the literature on ESM investment. Section 3 introduces the dataset and presents some descriptive statistics. The case for investing in CEE markets is examined in Section 4 and the nature of the possible gains from CEE equity investment is explored in Section 5. The final section offers a number of concluding observations.
This paper has investigated a number of issues pertinent to investment in emerging CEE equity markets. Employing weekly disaggregated data over the period 1998–2003, the paper examined the size and nature of the gains from investing in CEE ESMs. The results are impressive; the optimal CEE portfolio significantly outperformed its developed market counterparts in the UK, the US and the World over the time period analysed, in terms of both return and risk. In particular, the optimal CEE portfolio recorded an impressive performance in the latter half of the time period investigated; for example, it delivered an MRPUR of 2.22 in 2002 as compared to a ratio of −0.11 for the UK index. The degree of outperformance varied over time and was smallest during the Russian Rouble crisis. However, the gains from investing in these CEE emerging markets were still sizeable, even during times of financial crisis. Finally, an investigation into the structure of CEE equity returns advocated a geographic top–down approach to investing in this region; the choice of industries or the selection of individual securities is likely to have less influence on the performance of a portfolio comprised of CEE shares than the selection of the ‘right’ countries in which to invest. However, in spite of the study's success in achieving substantial gains from portfolio diversification, the analysis suggested that equity investors in the CEE region must proceed with great care and be alert to the possibility of changes in the pattern of returns over time.
