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Emerging markets have become increasingly important to equity investors due to their fast growing economies. But what is the relationship between risk and return in these markets? Answer: it is flat or even negative. Empirical results show that the volatility effect - long-term equity returns at distinctly lower downside risk - is significant, robust and distinct.
At the end of each month between December 1988 and December 2010, emerging market stocks were sorted into five portfolios, according to volatility. The top quintile contained the stocks with the highest risk and the bottom quintile, the stocks with the lowest risk. The universe was defined as the equally-weighted portfolio of all stocks in the S&P/IFC Investable Emerging Markets Index. All portfolios were equally weighted and constructed in a country neutral manner. We next calculated portfolio returns in US dollars over the subsequent month and then repeated this process. After adjusting for market beta, the difference in returns between the top and the bottom ranked quintile portfolios is the alpha spread. A negative alpha spread means that less volatile stocks have higher risk-adjusted returns. Portfolios are also based on beta and other factors (size, value and momentum).