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70 COUNTRY, INDUSTRY, AND RISK FACTOR LOADINGS IN PORTFOLIO MANAGEMENT SUMMER 2002
variation of international stock returns. The first step, try dimensions. Carrieri, Errunza, and Sarkissian [2000,
which is estimation of the model, follows Heston and p. 26] conclude that: “In other words, ... investors should
Rouwenhorst [1994, 1995] and Griffin and Karolyi use both cross-country and cross-industry diversification
[1998].1 as a way to improve portfolio performance” (emphasis in
In the second step, unlike previous authors, we sep- the original).
arate the cross-sectional variance of monthly interna- More important, the globalization of the economy
tional stock returns into different effects, and then study has also strengthened the role of global risk factors as a
the evolution of each component. Our work differs from source of variation in international stock returns. While
other research in two key areas: the data set used, and, the main trends of the country/industry analysis remain
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more important, the inclusion of global risk factor load- the same, global risk effects became stronger during the
ings in the analysis. sample period, and are currently more significant than
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Our data, taken from Standard & Poor’s Compustat country and industry effects. Consequently, global man-
Global Vantage, cover 20 developed countries and 11 agers should consider exposure to these global risk fac-
broad industries, and span the period July 1989 through tors when they construct their portfolios.
December 2000. An advantage of our data set is that it
covers a great number of stocks (7,348 firms), making it DATA
possible to obtain more cross-sectional variance in the size
characteristics of firms. Our data set, extracted from the Standard & Poor’s
The more distinctive element of the research per- Compustat Global Vantage database, spans the period July
tains to inclusion of global risk factor loadings in the 1989–December 2000, and covers a total of 20 countries
model. Studies examining the relative importance of and 11 industries.2 The set covers 7,348 stocks, more
country and industry effects as a source of variation in than other studies, and includes small-capitalization stocks,
international stock returns have assumed identical global which enables us to obtain more cross-sectional variance
risk exposure for each stock. Yet authors have demon- in size factor loadings.3
strated the presence of global premiums related to size The sample includes all firms for which information
(Heston, Rouwenhorst, and Wessels [1995]), book-to- as follows is available: dollar-denominated total return,
market (Arshanapalli, Coggin, and Doukas [1998], Fama market capitalization, book-to-market ratio, and a descrip-
and French [1998]), and price momentum (Rouwen- tion of the industry and country affiliation.4 Exhibit 1 pro-
horst [1998]) (see Liew and Vassalou [2000] for evidence vides descriptive statistics on the returns observed from
on these three premiums). We use a global four-factor January 1992 through December 2000.
pricing model to control for differences in global risk fac- Panel A gives the main return characteristics by
tor loadings between international stocks. country. On average, we examine 367 firms per country,
Using a country/industry dummy variable frame- but the number of firms and industries varies by coun-
work, we show that country effects dominated industry try. The United States is by far the most represented, with
effects during the 1992-2000 sample period, corroborat- almost one-quarter of the firms covered (1,757 firms)
ing the findings of Heston and Rouwenhorst [1994, followed by Japan (1,682 firms), and the United Kingdom
1995] and Griffin and Karolyi [1998]. Consequently, (908 firms).
country diversification was on average more efficient than With the exception of Finland, the most volatile
industry diversification during the nineties. Like Baca, index returns are observed in the Far East countries. Fin-
Garbe, and Weiss [2000], Cavaglia, Brightman, and Aked land (4.04% per month) and Sweden (2.09% per month)
[2000], Kerneis and Williams [2000], and Hopkins and are the countries with the highest cap-weighted average
Miller [2001], we also note that industry effects have return. Austria and Japan recorded the poorest average
gained in importance. The ongoing trend toward inte- returns (respectively, –0.12% and 0.16% per month). The
gration has reduced the benefits of country diversification; low tracking error between the index returns of the
consequently, industry-oriented approaches to global G-7 countries and their corresponding MSCI country
management could be as effective as country-oriented index returns is a guarantee of the quality of our data.
approaches in the future. Panel B provides the main return characteristics by
Top-down approaches to global equity portfolio industry. The number of firms in industries varies from
allocation should consider both the country and indus- 1,837 for consumer cyclicals to 62 for communication ser-
Standard
Panel A. Countries Number of Firms Weight Return Deviation
Australia 241 1.41 0.80 5.06
Austria 61 0.17 -0.12 5.04
Belgium 64 0.67 0.91 3.83
Canada 363 2.23 1.05 5.57
Denmark 81 0.34 0.82 4.89
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Standard
Panel B. Industries Number of Firms Weight Return Deviation
Basic Materials 712 6.02 0.56 4.18
Capital Goods 1345 8.91 0.89 4.24
Communication Services 62 9.93 0.86 6.19
Consumer Staples 786 9.86 0.84 3.11
Consumer Cyclicals 1837 12.30 0.57 3.75
Energy 206 4.24 1.15 4.75
Financials 909 19.50 1.17 4.59
Health Care 290 6.82 1.29 4.29
Technology 722 15.75 1.92 6.69
Transportation 288 2.53 0.33 3.76
Utilities 191 4.14 0.81 2.84
Mean 668 9.09 0.94 4.40
Median 712 8.91 0.86 4.24
Standard
Panel C. Global Risk Factors t-test Return Deviation
Rw 2.80 1.00 3.72
Rw-rf 1.69 0.61 3.72
SMBw 0.74 0.21 2.93
HMLw -0.23 -0.08 3.60
WMLw 2.20 0.76 3.58
Returns are expressed in USD. Weights, returns, and standard deviations are expressed in percentage on a monthly basis.
72 COUNTRY, INDUSTRY, AND RISK FACTOR LOADINGS IN PORTFOLIO MANAGEMENT SUMMER 2002
vices. Over the period considered, technology (1.92% per wise, Iij is a dummy variable that equals 1 when firm j
month) and health care (1.29% per month) posted the best belongs to industry i (i = 1, …, 11) and 0 otherwise, and
returns; basic materials (0.56% per month) and consumer ejt is the error term.
cyclicals (0.57% per month) posted the lowest returns. The To solve the identification problem induced by
technology returns were the most volatile (6.69% standard dummy variables and to facilitate interpretation of the
deviation of monthly returns). At the other extreme, util- coefficients, we impose the same restrictions as Heston and
ities returns registered a standard deviation of only 2.84%. Rouwenhorst [1994, 1995] and Griffin and Karolyi [1998]:
Panel C shows the average return and standard devi-
ation of each of the four global risk factors: the global mar- 20
∑γ φ =0 (2-A)
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where Rjt is the return of firm j (j = 1, …, N = 7,348) The analysis considers fixed country and industry
for period t, Ccj is a dummy variable that equals 1 when effects exclusively, and assumes that all stocks have the same
firm j belongs to country c (c = 1, …, 20) and 0 other- global risk exposure. Our main contribution is to exam-
74 COUNTRY, INDUSTRY, AND RISK FACTOR LOADINGS IN PORTFOLIO MANAGEMENT SUMMER 2002
Rouwenhorst conclude: “There are substantial benefits to tion included in this panel somewhat resembles that of
international diversification beyond the amounts Exhibit 2, except that it introduces the differences in
attributable to industrial or currency diversification” global risk exposure as a source of variation in interna-
[1994, p. 26]. tional stock returns.
This result nevertheless overshadows the evolution The stock-specific component remains very high at
of country and industry effects. There has been a signif- 72.75% on average (a slight decline from a level of 73.75%
icant shift from country to industry influences in recent with fixed effects only). For the entire sample period,
years. Indeed, the relative importance of country effects country effects on average continue to dominate indus-
declined significantly during the period studied, dropping try effects (14.77% versus 7.64%). While the fixed effects
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from 26.81% of the total effects in 1992 to 7.85% in model assumes that all stocks have the same global risk
2000. This decline is consistent, except for 1997. exposure, results here show that global factor loadings
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Conversely, the relative importance of industry effects explain on average 4.83% of the return variance.
has continued to increase. The portion of the global return As in the analysis based solely on country and indus-
variance accounted for by industries increased from 5.54% try fixed effects, the relative importance of country effects
in 1992 to 17.39% in 2000. As a result, industry effects in the variation of international stock returns has drasti-
exceeded country effects as a source of variation in cross- cally declined (from 22.07% in 1992 to 8.20% in 2000).
sectional returns for 1999 and 2000. During these two Industry effects have gained concomitantly in impor-
years, diversification across industries would have been tance; they represented 4.62% of the cross-sectional vari-
more advantageous than diversification across countries. ance in 1992 versus 10.71% in 2000. Since 1999, industry
This result is consistent with results in Baca, Garbe, effects have even surpassed country effects.
and Weiss [2000], Cavaglia, Brightman, and Aked [2000], The most interesting result pertains to global factor
and Hopkins and Miller [2001]. Hopkins and Miller loadings. From 1992 to 2000, the global factor loadings
emphasize that the increase in industry effects is indica- as a source of variation in international stock returns have
tive either of more extreme sector returns around the grown so dramatically—increasing from 6.20% in 1992 to
global average or of the rising importance of sectors as 11.51% in 2000—that global factor loadings outweighed
drivers (information technology, energy, and utilities). country and industry effects in 2000. As the global factor
loading effects are non-diversifiable, we can conclude that
Fixed Effects and Global Factor Loadings benefits of international diversification have been signifi-
cantly declining in more recent years, particularly in 2000.
Exhibit 3, Panel A, presents the results of estimation Exhibit 3, Panel B, shows the breakdown of the
of Equation (4), which combines both fixed country/indus- global factor loadings into four components. The corre-
try effects and global risk factor loadings. The informa- lations between the four global risk factor loadings aside,
EXHIBIT 3
Evolution of Stock-Specific, Country, Industry, and Global Risk Effects
Panel A Panel B
Year Stock-Specific Country Industry Global Market Size B-to-Mkt Momentum
1992 67.11 22.07 4.62 6.20 0.77 0.96 2.62 2.41
1993 67.19 21.84 6.46 4.52 0.43 1.27 1.07 1.56
1994 71.92 19.15 5.85 3.07 1.32 0.95 0.45 0.38
1995 75.11 15.69 5.73 3.47 0.89 1.19 0.44 0.59
1996 78.23 13.51 6.09 2.17 0.71 0.57 0.25 0.59
1997 72.00 16.64 7.15 4.21 0.53 1.68 0.69 2.10
1998 75.51 13.49 7.24 3.76 1.51 0.36 1.23 0.78
1999 72.47 9.68 11.90 5.96 3.70 0.35 1.64 0.39
2000 69.59 8.20 10.71 11.51 2.60 2.61 2.72 1.31
Mean 72.75 14.77 7.64 4.83 1.46 1.12 1.06 0.96
Median 72.23 14.60 6.80 3.99 1.11 1.07 0.88 0.69
the momentum loadings declined from 2.41% in 1992 to 1998 74.69 13.30 8.40 3.61
1.31% in 2000. 1999 71.47 9.84 12.74 5.96
2000 68.08 8.27 12.18 11.47
Mean 70.95 15.59 8.52 4.94
ROBUSTNESS OF RESULTS Median 71.19 15.61 7.86 4.07
Panel B. Four Largest Stock Markets
We also analyze the sensitivity of the results to the 1992 68.50 16.94 5.61 8.96
definition of industries, the number of countries studied, 1993 70.11 15.09 8.38 6.43
and firm size. First, we analyze whether the tests could 1994 75.92 12.11 7.64 4.34
be biased against finding any industry effects. Following 1995 74.88 13.17 7.42 4.53
Griffin and Karolyi [1998], we use a more refined classi- 1996 78.64 10.88 7.69 2.80
fication of industry sectors, to include 21 subindustries 1997 74.16 11.44 8.77 5.63
rather than 11 industries. 1998 78.45 8.11 8.83 4.61
We also examine the results for a possible bias toward 1999 74.25 5.96 12.98 6.81
finding country effects by considering only the four largest 2000 70.78 5.02 11.76 12.44
stock markets: United States, Japan, United Kingdom, and Mean 73.96 10.97 8.79 6.28
Germany (77% of the global market capitalization for Median 74.25 11.44 8.38 5.63
Panel C. 25% Largest Companies in the World
1992–2000). In addition, we look at how the country,
1992 60.95 24.40 5.92 8.73
industry, and global factor loadings effects behave when
1993 60.65 23.85 8.69 6.81
managers are restricted to the largest global stocks.
1994 66.71 21.25 7.68 4.36
Exhibit 4, Panel A, shows the results for a classifi- 1995 69.58 16.62 7.24 6.57
cation based on 21 subindustries. Such a classification 1996 73.70 15.54 7.87 2.88
slightly amplifies the industry effects for all the years con- 1997 69.59 16.76 8.93 4.73
sidered. Compared with Exhibit 3, the average industry 1998 73.65 13.83 8.32 4.20
effect rises from 7.64% to 8.52%. This modest increase in 1999 69.82 10.23 13.18 6.77
industry effects is accompanied by a slight increase in 2000 67.49 8.65 11.60 12.26
country effects (14.77% to 15.59%), mostly to the detri- Mean 68.02 16.79 8.83 6.37
ment of stock-specific effects, which decline on average Median 69.58 16.62 8.32 6.57
from 72.75% of the total effect to 70.95%.
Consequently, we conclude that the industry clas-
sification has little impact on average results, consistent drop translates into an increase in the relative importance
with Griffin and Karolyi’s [1998] finding. The declining of industry and global risk effects.
weight of the country effects persists with the more Industry effects are clearly stronger when we con-
refined industry classification, while the upward trend of sider only the four largest markets (8.79% versus 7.64%).
global and industry effects remains the same. Moreover, industry effects dominate country effects as
Exhibit 4, Panel B, shows the results when the early as 1998. The average global risk effects, meanwhile,
global portfolio manager is limited to the U.S., Japan, the increase from 4.83% to 6.28%. The reduced benefits of
U.K., and Germany. Compared with Exhibit 3, the aver- international diversification are thus more marked if we
age country effects decline from 14.77% to 10.97%. This consider the four largest stock markets exclusively.
76 COUNTRY, INDUSTRY, AND RISK FACTOR LOADINGS IN PORTFOLIO MANAGEMENT SUMMER 2002
Panel C shows the stock-specific, country, industry, role of global risk factors in explaining co-movements in
and global risk effects when only the top 25% of firms in international stock returns. The extent of stock market
terms of market capitalization are considered. Kerneis and returns explained by differences in exposure to global
Williams [2000] have shown that the large-cap stocks have risk factors rose considerably during the period covered.
a more sensitivity to global industry factors than the total Global risk effects dominated both country and industry
universe. Our earlier results are not materially changed by effects in 2000, with 11.51% versus 10.71% for industry
restricting the total universe to large-cap stocks. effects and 8.20% for country effects. Global management
Like Kerneis and Williams [2000], we note that the strategists could consequently delineate asset classes on the
stock-specific components have less impact in the large- basis of their global risk factor loadings.
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cap universe. This decline of the stock-specific component The trend toward globalization is instrumental in
results in heightened industry effects (from 7.64% to determining the relative importance of country, industry,
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8.83%), country effects (from 14.77% to 16.79%), and and global risk effects. The structural changes in global
global risk effects (from 4.83% to 6.37%). Even for large- economies probably explain why in the last decade coun-
cap companies, country effects have on average dominated try effects have been losing ground in favor of industry
industry effects during the period of 1992-2000. Indus- and global risk effects. Given that these three effects have
try and global risk effects, however, are still more appar- become equally important in the recent period, it is best
ent than country effects in 1999 and 2000. to consider all three dimensions—country, industry, and
global risk factors—in constructing portfolios.
SUMMARY
APPENDIX
We have compared the relative importance of coun-
try, industry, and global factor loading effects in explain- Construction of Global Risk Factors
ing the variation in international stock returns during the
1990s (from January 1992 through December 2000). We As we focus on both country and industry effects, we do
not compute global factors as weighted averages of country (see
factor a risk dimension into the analysis, making it pos-
Fama and French [1998]) or industry factors. Instead, we com-
sible to identify the portion of the variation in interna-
pute them regardless of countries or industries.
tional returns attributable to global risk levels incurred. For each month t from July of year y – 1 to June of year
If we consider the country and industry dimen- y, we rank stocks based on size and book-to-market ratio of June
sions exclusively, on average country effects dominated y – 1 and their previous performance between t – 12 and t –
industry effects over the entire period. Consequently, 1. We perform independent sorts beginning in July 1990 to cre-
diversification across countries was on average more effi- ate SMBw, HMLw, and WMLw. We use 50% break points for
cient than diversification across industries. size, and 30% and 70% break points for book-to-market and
Country effects declined significantly during the prior performance.
nineties, however. The portion of the return variance Following Fama and French [1993], we form six global
attributable to country effects declined from 26.81% in value-weight portfolios, S/L, S/M, S/H, B/L, B/M, and B/H,
1992 to only 7.85% in 2000, a decrease of 70.72%. Indus- as the intersection of size and book-to-market groups. We fol-
low the same procedure for prior performance as for book-to-
try effects came to play a greater role in explaining the vari-
market; that is we form six global value-weight portfolios,
ance of international stock market returns, shifting from
S/L, S/M, S/W, B/L, B/M, and B/W, as the intersection of
5.54% in 1992 to 17.39% in 2000; they dominated coun- size and prior performance groups. SMBw, HMLw, and WMLw
try effects in both 1999 and 2000. Thus, ongoing global are as follows: SMBw = [(S/L – B/L) + (S/M – B/M) + (S/H
integration has made industry-oriented approaches to global – B/H)]/3, HMLw = [(S/H – S/L) + (B/H – B/L)]/2, and
investment as effective as country-oriented approaches. WMLw = [(S/W – S/L) + (B/W – B/L)]/2.
By implication, global management strategies should Consequently, our methodology can be compared directly
pay greater attention to the benefits of industrial diversi- to neither that of Liew and Vassalou [2000], who use three
fication. As country effects remain more than trivial, sequential sorts, nor to that of Arshanapalli, Coggin, and Doukas
however, asset classes should be defined using both coun- [1998], who use 70% and 30% break points for SMB and con-
try and industry dimensions to maximize the benefits of struct HML by selecting the highest book-to-price stocks until
diversification. half of the capitalization of each market is accumulated.
Furthermore, globalization has strengthened the
( ) ( )
and Rouwenhorst [1994], among others.
ˆ ˆ
Rwt Var αˆ wmt β wmjt SMBwt Var αˆ wst β wsjt
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2
The countries are Canada, the United States, Malaysia,
= , =
and 17 of the 20 countries in the EAFE index. Like Cavaglia, Tt Tt Tt Tt
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( ) ( )
Brightman, and Aked [2000], we focus only on developed
ˆ ˆ
countries that are more economically integrated in order to HMLwt Var αˆ wbt β wbjt WMLwt Var αˆ wwt β wwjt
= , and =
avoid a possible country bias effect related to emerging coun- Tt Tt Tt Tt
tries. The Compustat database defines 12 industries. There are
few firms and only four countries in the biotechnology sector, The sum of these individual components is not equal to
so we group it with the information technology sector, result- the global factor loadings effect, Gt/Tt because this latter term
ing in 11 industries. To analyze the sensitivity of results to the considers the covariances between these components.
definition of industries, we use the first two digits of the Com-
pustat 103-sector additional classification, leading to a classifi-
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