A growing body of evidence suggests that the benefits of international diversification via developed markets have declined dramatically. While emerging markets still offer diversification opportunities, their public equity indices capture only a fraction of emerging countries' economic activity. We propose a diversification approach that exploits the global connectedness of developed countries to gain exposure to emerging countries' overall economies rather than their shallow equity markets. In doing so, we demonstrate that developed markets still offer substantial diversification benefits beyond those available through equity indices. Our results suggest that relying on equity indices to assess diversification benefits understates diversification gains.

We present empirical evidence that the innovation in global equity correlation is a viable pricing factor in international markets. We develop a stylized model to motivate why this is a reasonable candidate factor and propose a simple way to measure it. We find that our factor has a robust negative price of risk and significantly improves the joint cross-sectional fits across various asset classes, including global equities, commodities, sovereign bonds, foreign exchange rates, and options. In exploring the pricing ability of our factor on the FX market, we also shed light on the link between international equity and currency markets through global equity correlations as an instrument for aggregate risks. This paper was accepted by Karl Diether, finance.

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