The correlation between emerging markets and developed markets has increased but is still comparatively low. Part of the problem is one of perception. Investors like the idea that at least some part of their portfolio is going up while the rest falls sharply. When fund managers talk about diversification benefits, the investors hope that this includes some markets rising against a background of general gloom. What low correlation now seems to mean is that markets rise and fall together but at different speeds.

The behaviour of emerging markets has changed in recent years. The change began in 1993 when all emerging markets rose sharply in response to huge inflows of funds from the US and, to a lesser extent, from other developed countries. This was the year when foreign investors began to exert a large influence on emerging market be-haviour. The price of this change was seen during the "Tequila crisis" when problems that were specific to Mexico caused emerging stock markets in Latin America and Asia to fall sharply. Capital inflows to emerging markets have remained large since 1993 but have been subject to considerable pauses during times of sharp market corrections. Foreign investors now own, in many emerging markets, the major part of freely traded shares. It is not surprising that emerging markets now move together. The investors who trade those markets work for international institutions and are subject to in-ternational pressures.

The presence of international in-vestors has not made emerging markets any more efficient in the technical sense. Traditionally emerging markets have been subject to wild swings in valuation, from being grossly over-valued to under-valued and back again. They have been 'mean reverting' with their pasts carrying messages about their future. There are no signs of this ending. This is surprising. We might expect that the presence of a group of sophisticated investors should change the be-haviour of these markets. Why are the markets still as volatile as ever?

The answer to this lies in the attitudes of international investors. Most of them do not view themselves as having a natural exposure to any one emerging market even though they have a commitment to emerging markets as an asset class. This makes it possible for emerging market international investors to cause flows of funds that are large in the context of the level of domestic trading in any market. Experience has taught international investors that these markets are likely to have strong trends and that trend following can pay for considerable periods. It is clear from fund performance and reported asset allocation that international managers have been reducing Asian weightings through 1997. This may have sped up the pace of adjustment in emerging markets.

It seems likely that the case for investing in emerging markets will have to be made in terms of prospective returns rather than in terms of diversification benefits. This is difficult to do currently if it is done in terms of the historic performance of emerging and developed markets in recent years. It has to be done in terms of the relative valuations of developed and emerging markets.

The correlation between the S&P 500 and the IFCI composite index peaked at more than 0.5 at the end of 1994 and has trended downwards since then to below the level of end 1993. A large part of this falling correlation is a statistical artifact - the number of markets covered by the IFCI has risen sharply. The older emerging markets have continued to be linked increasingly to the developed markets but the addition of other markets to the index has masked this change.

Kenneth King is head of emerging markets at State Street Global Advisors in London