Changes in stock market behaviour are forcing a new look at international diversification: Should we diversify across industries or across countries?

Portfolio finance theory suggests that investors should not put all their eggs in one basket. They should look at how different types of assets move against each other for they can achieve equally high returns and more stability than by investing in one type of asset alone.

Traditionally asset allocation strategy has been based on the country-oriented approach where diversification takes place across countries. Fund managers look at the correlations of countries' stock market returns and select those which do not move in tandem. Selecting the countries to invest in is the big strategic decision, and picking companies within the countries is the secondary decision. Our research has examined whether this approach to international diversification continues to be appropriate given developments in stock markets. Correlations between the US and other developed countries' stock markets have risen markedly, reflecting the increase in the harmonisation of economic, monetary and fiscal policies, especially in the Eurozone, and the trend towards a general deregulation of markets and progressive elimination of barriers to international investments.

Our research has concluded that a country oriented approach to diversification might not always be the correct avenue to asset allocation. A better way might be to diversify across industries i.e. to look at the correlation of each industry with the global weighted industry index return and select firms in that industry. Thus, a firm's domicile becomes less important, whereas the industry in which the firm's operation lies becomes more important. In our research we examine how much of the movement of the Honda equity return is due to the fact that Honda is in the automobile industry and how much is due to the fact that Honda is a Japanese firm. This is what has been termed the industry versus the country effect. If the industry effect is found to dominate the country effect then diversification across industries should be preferred.

Our work is the first to include emerging markets in the analysis. This is important for emerging markets behave differently compared to developed markets. Furthermore, there is a growing interest in those markets by foreign investors. Previous work has concentrated on developed markets, or on a certain region such as Europe, and used broader industry sectors rather than the partitioned industry groups. An analysis of returns consisting of fewer countries and a smaller number of industry groups, analogous to examining portfolio returns less diversified across countries and industries, may reduce the power of the tests and induce bias in the estimation. Furthermore, our broad sample of countries allows us to study the differences of the country and industry effects across regions, and between emerging and developed countries. Looking at various samples we are able to study how these effects have changed over time.

Methodology

In our research we examined the country/industry effect at the market level and used the data from the Dow Jones Global Indexes (DJGI), which are based on 50 well partitioned industries and 34 worldwide countries (11 of which are Emerging markets) for the period of Jan 1992 – Dec 2001.

Using factor decomposition technique, which is frequently employed in the literature, we decompose returns into global, industry, country factors and an error term, where industry and country factors are dummy variables. The error term picks up whatever cannot be explained by these factors.

We apply two methods to gauge the importance of industry versus country effects: the variances and the Mean Absolute Deviation (MAD).

The larger the variance of one effect, the higher the proportion of returns explained by that effect, therefore the more important that effect will be. In comparing the relative importance of country and industry effects we look at the ratio of the variances of the country versus the industry effect. If that is greater than one, that implies that the country effect continues to be dominant.

The Mean Absolute Deviation (MAD) of the industry (country) effect is defined as the absolute value of estimated industry (country) effect in time t multiplied by the corresponding market cap at that time. It can be thought of as the cap-weighted returns of "perfect foresight" strategies that are exclusively based on either country or industry tilts. The country MAD can be interpreted as the capitalisation weighted average tracking error for returns on industry-neutral country portfolios. The industry MAD has an analogous interpretation.

Apart from the global effect, we also examine the two effects across regions of Europe, Asia Pacific, North America and Latin America. The industry effect may vary across regions because of the varying degree of economic integration and the formation of regional economic and trading blocks such as EU, NAFTA and ASEAN. We also sub-divide our sample into three periods to inves-tigate the changing processof the two effects.

Results

Variance Analysis

Our key results can be summarised in Charts 1-3 and Table 1. Chart 1 shows the country and industry effect variances for all the countries, both developed and emerging markets, for the whole period and the three sub-periods: sub-period 1: 0192-395; sub-period 2: 0495-1199: and sub-period 3: 1299-1201.
 

As can be seen, the country effect has remained dominant throughout the period. However, the relative importance of the country effect has been reduced as the ratio of the two effects has fallen from 4.78 at the beginning of the 1990's to 1.3. at the turn of the century. The rising importance of the industry effect has been more prominent in some of the industries. During the third period, over one fifth of the industries had an industry effect higher than the average country effect. Such industries include not only technology and telecommuni-cations industry groups, such as biotechnology, semiconductors,communications technology, software, but also other industries, such as consumer services, tobaccos, entertainment, household products and advertising.

These global results however mask differences between the various regional groups and between developed and emerging markets. Chart 2 shows that during the entire period of 1992-2001, the country effects had dominated the industry effects in all the regions except North America. The country effects for Latin America and Asia Pacific were much higher than those for Europe and North America. The ratios of country/industry effects were 5.25:1, 3.57:1 and 1.49:1 respectively for Latin America, Asia Pacific and Europe (see Table 1). Yet judging from sub-periods, the ratios for all the three regions were continuing to decrease (except for Asia Pacific in the second sub-period when the Asian crisis occurred). The ratios in the last sub-period were down to 1.44:1, 1.8:1 and 1.05:1 respectively for the above three regions. Especially in Europe, the industry effects almost levelled the country effects.
 

Table 1. Geographical country effects vs. industry effects (Variance: %-squared)

Panel A reports the geographical breakdown of country effects as a comparison to the global industry average.
Panel B shows the average country effects between developed and emerging markets as opposed to the global industry averages.

The decreasing ratios across all the regions imply a tendency that not only in Europe, but globally, equity markets have become increasingly integrated. The only difference across regions is that the industry effects in Europe were catching up with the country effects at a faster rate. Chart 3 confirms our geographical breakdown analysis that the emerging markets tend to have larger country effects although their relative importance is diminishing.

MAD Analysis

The MAD estimation in our analysis gives similar conclusions…it indicates that the world had witnessed a major shift in the sources of importance in the return variation: industry effects began to dominate the country effects in recent years. Yet the situation varies across regions: while the industry effects became more important in Europe and North America in recent years, they were still dominated by the country effects in the regions of Asia Pacific and Latin America. This finding supports the view that the start of EMU as well as the introduction of the single European currency have accelerated the economic integration in the region compared to the other regions. On the other hand, the industry effect lost its dominance in North America for a short time in 2000, possibly relating to the burst of technology bubbles.

What is driving these changes in the importance of country and industry influences on stock returns?

The above results raise the following questions: Is the increasing importance of the industry effect due to the IT bubble and driven by a narrow set of industries such as, Technology, Media and Telecommunication (TMT)? Is the increasing importance of industry effect closelyrelated to the ongoing capital market integration which has reduced country influences? Does it relate to business globalisation, which makes firms' profitability, cash flows and asset values more sensitive to external shocks?

We have provided answers to the above questions in another study of ours where we performed a similar analysis but at the firm level rather than at the market level1. We looked at returns from 2,179 companies across 23 developed and 27 emerging markets between 1990 and 2002. Having estimated the country and industry effects we examined whether they are drivenby the firm's characteristic factors, such as its international business, proxied by the firm's foreign sales, by its degree of market integration, proxied by whether the firm has an ADR on the New York Stock Exchange and finally by its TMT affiliation.

Our results show that a rise in a firm's international sales decreases the firm's country effect. Thus, firms which trade substantially with the rest of the world are more sensitive to external factors such as international input and output price fluctuations and changes in exchange rates, rather than domestic factors. Having an ADR, however, has a mixed impact. It increases the industry effect as well as the country effect. On the other hand, we find no supporting evidence that the increase of industry effects is confined to TMT sectors due to the IT bubble.

What advice can we give to fund managers on the basis of these results?

• Conventional wisdom has been to diversify across countries. Our research shows an increase in the relative influence of global industry factors over country specific factors in stock returns. In fact, for industries such as semiconductors, consumer services, technology, household products, tobacco and entertainment, it is more favourable to allocate assets across industries. Particularly in Europe and North America, where the industry effects have levelled or even surpassed the country effects, diversification across industries should be preferred. The increasing industry effects have not be driven by the IT bubbles at the turn of the century but are embedded in the long-term globalisation process.
• The traditional cross-country diversification remains, however, valid for emerging markets despite the increasing correlations in those markets following a series of capital market liberalizations in the 1990s. However, the industry influence has been increasing significantly in recent years.
• In selecting individual stocks, a fund manager should also be looking at the characteristics of a firm, such as the extent of its international business and whether it has an ADR listing. An efficient way would be to choose companies that are cross-listed as ADRs, and have less international business and are primarily from emerging markets.

References

1. Kate Phylaktis and Lichuan Xia, 2006, "Sources of Firms' Industry and Country Effects in Emerging Markets", Journal of International Money and Finance, forthcoming
2. Kate Phylaktis and Lichuan Xia, 2006, "The Changing Roles of Industry and Country Effects in the Global EquityMarkets", European Journal of Finance, forthcoming