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Global Diversification: By Country or Industry?

| | Posted in: Strategic Allocation

With increasing business globalization and financial markets integration, can equity investors still get good risk reduction by diversifying their portfolios across country markets? Or, have other kinds of diversification become more important? In their paper entitled “The Changing Roles of Industry and Country Effects in the Global Equity Markets”, Kate Phylaktis and Lichuan Xia examine the evolution of country and industry effects on stock returns and diversification. Using weekly returns from the Dow Jones Global Indexes (DJGI) encompassing 4,801 companies in 51 industry groups across 34 countries over the period 1992 to 2001, they find that:

  • Over the entire period, the U.S. produces the highest average return of all countries. Emerging countries have higher volatilities than developed countries.
  • Industries are generally less volatile than country markets, but industry volatility increases significantly over the sample period.
  • For the full sample period, country effects dominate industry effects as contributors to variation in international returns (sources of effective diversification). However, industry effects grow rapidly such that they exceed country effects near the end of the sample period.
  • The increasing relative importance of industry effects holds in all regions. However, industry effects are more important in developed markets (North America and Europe) than in emerging markets (Asia-Pacific and Latin America), where country effects are still the dominant sources of effective diversification.
  • Some industry sectors (such as semiconductors, technology, consumer services and entertainment) are especially important sources of variation (diversification).
  • Global investors should increasingly ensure portfolio diversification across industries in comparison to diversification across countries, especially for North America and Europe.

The following figures, taken from the paper, use capitalization-weighted 52-week moving averages to illustrate the growing relative importance of industries as sources of global variation in stock returns (and therefore sources of effective diversification for global investors). The vertical axis for each figure delineates the Mean Absolute Deviation (MAD) of returns as measures of industry and country contributions to variation in global returns. They show that, at least among developed countries, industries become more important sources of variation in stock returns than countries.

In summary, global integration is rapidly shifting the balance of diversification power from countries to industries (for investors who adhere to modern portfolio theory).

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