The Increasing Importance of Industry Factors

Previous studies of the relative importance of industry and country factors in determining equity returns generally concluded that country factors dominate industry factors. We present evidence that industry factors have been growing in relative importance and may now dominate country factors. Furthermore, our evidence suggests that over the past five years, diversification across global industries has provided greater risk reduction than diversification by countries. These findings suggest that industry allocation is an increasingly important consideration for active managers of global equity portfolios and that investors may wish to reconsider home-biased equity allocation policies. Accelerating globalization of business enterprise and integration of capital markets are altering the equity investment environment. We consider whether these global changes have affected the relative importance of industry and country factors to equity returns. We present new evidence demonstrating a marked structural change in the factors determining global equity returns during recent years. We show that industry factors have been growing in relative importance and may now even dominate country factors. Thus, in the future, investors may increasingly perceive an integrated global equity market rather than a collection of separate country markets. We review the growing literature aimed at measuring the importance of industry and country factors. On balance, the studies suggest that industry factors have been relatively less important than country factors. These conclusions are sensitive, however, to the model estimated, the countries considered, the industry definitions used, and the time period analyzed. We present a factor model of global equity returns. The data cover 21 countries that constitute the MSCI World Developed Markets universe and, to measure the performance of portfolios of securities belonging to the same industry within a country, 36 industry-level national total return indexes of the FT/S&P Actuaries World Index. We fit a multiple-factor model to these data to estimate the return contribution emanating from exposure to either pure country factors or pure global industry factors for the period 1986 through 1999. We used the mean factor-return estimates from this model to measure the opportunities for outperforming the world index with systematic industry- or country-based tilts. We found that since early 1997, the return opportunities from industry tilts have dominated those emanating from country tilts. We also used the factor model estimates to draw inferences about the relative merits of international strategies involving diversification by industry and/or by country. For the most recent decade, we found a rising correlation of country factor returns, which suggests diminishing gains from diversifying by country. Conversely, industry factor correlations were relatively stable over the decade. By 1999, when we used the most recent 52-week window of data, the capitalization-weighted correlation of industry factor returns equaled that of countries. Our factor model estimates suggest that the gains from diversifying by industry are now larger than the gains from diversifying by country. Clearly, however, diversifying by both factors is optimal. The increasing importance of industry factors as a determinant of global equity portfolio risk and return has several investment implications. First, unintended industry exposures that result from using equity benchmarks biased toward the home market may result in increasingly inefficient global asset allocations. Second, active global equity investment managers will increasingly need to balance the return-to-risk trade-offs of global industry allocations as well as of country allocations. Finally, stock selection opportunities may increasingly be found in comparisons of stocks among countries but within common global industries.