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World markets are integrating, but only gradually.
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Anton V. Puchkov, Dan Stefek, and Mark Davis
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nderstanding the sources of a portfolio’s return
th
i s U and risk is crucial for successful investing.
Investors focused on a single market com-
monly use multifactor models for this pur-
pose, models that may require more than 50 factors to
e
capture the behavior of local industries and styles. For global
c
investors, the situation is far more complex. Not only do
u
they have more markets to consider, but they also need to
d
understand the relationships between and among markets.
o
Financial researchers and practitioners have dealt
ill
ANTON V. PUCHKOV is movement of stocks within a market. The global indus-
manager of Integrated Model try and style factors reflect common movements of
Research at Barra, Inc., in
s
stocks in the same industry or with similar style charac-
i
Berkeley, CA.
teristics throughout the world. This scheme provides a
t
anton.puchkov@mscibarra.com
I
simple way to analyze performance, but in doing so
DAN STEFEK is a senior vice overlooks important information about local markets.
president, Research and Data, The investment processes of international equity
at Barra, Inc. managers reflect their views of the relative importance of
dan.stefek@mscibarra.com
these broad sources of return.1 Firms that believe in the
MARK DAVIS is a senior pro- primacy of country factors organize their teams region-
duct manager at Barra, Inc. ally. They allocate portions of portfolio value to coun-
mark.davis@mscibarra.com tries and then select securities in those countries. Firms
model uses a set of industries and styles tailored to fit its Âw ind i gind i =0 (3)
local market. i
20
a particular source, we examine the fraction
of the total cross-sectional variance coming
from that source. For example, the relative
15
contribution of the purely local factor would
be CSV 2(Xf)/CSV 2(r).
10 Investment Universes
Developed markets
75 models of international equity return and
risk. This has implications for both perfor-
50
Purely local
mance attribution and risk analysis. The con-
25 ventional approach to analyzing performance
Inter-market factors of global equity portfolio attributes return
0
1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 only to countries and global industries and
100
styles. The remaining return is then ascribed
Emerging markets to a manager’s ability to select stocks with
75 superior prospects.
Unfortunately, this approach fails to
50
Purely local account for the possibly sizable bets on purely
25 local factors that the manager may be taking.
Inter-market factors As a result, it will misclassify them as stock
0
1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 selection.
The same is true for risk control. Tra-
ditional models capture industry risk with
developed markets, broken into its components accord-
global factors. This suggests that a manager may hedge the
ing to Equation (5).
banking risk that arises from an overweight position in a
Asset-specific sources account for much of the dis-
Japanese bank by underweighting a U.S. bank. Clearly, the
persion in return. There is plenty of risk and opportunity
hedge would not rid the portfolio of the peculiar risks
for stock-pickers. More interestingly, the purely local and
inherent in either the Japanese or U.S. banking industries.
intermarket factors are of equal importance. The disper-
Purely local factors capture these differences and allow for
sion due to each is approximately half that due to asset-
more precise risk control.
specific sources. It is also interesting to note that the rise
Developed markets
75 however, are still by far the dominant influ-
ence in these markets.
50 Country
Global Industry
Global Style
25 Countries and Global Factors
in the Light of Recent History
0
1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004
A number of authors have noted the
100 increased relative importance of global indus-
75
try factors in developed markets. This natu-
rally raises questions about the nature and
50 Country Emerging markets permanence of the change.
Global Industry
Global Style Baca, Garbe, and Weiss [2000], Cavaglia,
25
Brightman, and Aked [2000], Hamelink,
0 Harasty, and Hillion [2001], Cavaglia and
1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 Moroz [2002], and L’Her, Sy, and Tnani [2002]
suggest that the increased importance of global
Countries or Global Factors? industries is due to ongoing economic integration and
We next focus on the intermarket factors and com- therefore is likely to be permanent. Results in Brooks and
pare the importance of countries and global industries and Del Negro [2002], Scowcroft and Sefton [2002], and Kritz-
styles. To analyze the contribution of each, we decom- man and Page [2003], however, are either inconclusive or
pose the dispersion due to these intermarket factors into suggest that it might be a transitory phenomenon.
three components: 8 With the benefit of data extending through Febru-
ary 2004, we can shed new light on this issue. The first
graph in Exhibit 4 shows that the dominance of global
CSV 2 ( XYg) ª CSV 2 ([ XYg]country ) + industry over country factors seems to have been a tem-
CSV 2 ([ XYg]global ) + CSV 2 ([ XYg]global ) (6) porary phenomenon. Beginning in 2002, countries have
industry style
once again become the most important intermarket fac-
Exhibit 4 shows the amount each source contributes tor. That said, there has been a shift over the last 12 years
to the total dispersion from intermarket factors for both toward global industries and styles. Today they account for
developed and emerging markets. roughly 40% of the total dispersion due to intermarket fac-
In the developed markets, countries have historically tors compared to 15% in 1992.
been the primary drivers of this dispersion, accounting for Why have global factors increased in relative impor-
roughly 75% of it through much of the 1990s. This is con- tance? Do countries now account for less return dispersion,
sistent with global investment managers’ practice of first in absolute terms? Do global factors account for more?
allocating funds along country lines. In 1998, however, To answer these questions, we plot the cross-sectional
the relative contributions of industry and style began to volatility attributable to each source in Exhibit 5. It varies
increase significantly. Country and industry contribu- considerably over the period, although there is a rise due
tions actually crossed on a few occasions between 1999 to all factors around the year 2000. During the technol-
and 2002, with industries briefly dominating countries. ogy bubble, soaring contributions from global factors
This led some practitioners to consider reorganizing their drove their increase in relative importance.
processes along global sector lines.9 Focusing on the end-points, we can see that the con-
The situation is more extreme in the emerging mar- tribution of countries has trended down over the period.
kets. Countries have historically accounted for an even The contributions of industries and styles, while fluctu-
higher percentage of the dispersion due to intermarket fac- ating over the period, have remained about the same.
4
The first three terms measure dispersion due
to global industry factors within each of the three
groups. The last term measures dispersion of the
3
average returns of these three industry groups. In
results different from our earlier analyses, this
cross-term is not negligible.11
2
Exhibit 6 plots the contributions of each rel-
ative to their 1992 levels. The results are quite
striking. The cross-sectional volatility arising from
1 within the new economy industry group increased
sixfold from its 1992 level to the peak in 2000. The
dispersion within the old economy and other
0
1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 industry groups also rose during that period, but
to a much lesser extent. The contribution of the
Global Industries and the Technology Bubble
cross-term mimicks that of the new economy
group. This reflects the large differences between the
Given the timing of the dramatic rise and fall of dis- extreme returns posted by the new economy industries and
persion due to global industries, it is natural to wonder the more modest returns earned by the old economy and
whether this reflects the technology boom and bust of the other industries.
same period. If so, we would expect high-technology indus-
tries to contribute disproportionately to the rise in indus- FINANCIAL MARKET INTEGRATION
try importance. This could happen through increased
dispersion within the high-technology group, or between The financial markets do appear to be integrating,
it and other industry groups. In fact, we find both to be true. although not at the pace suggested by the rapid rise in
We classify the global industries into three groups: global factors during the technology bubble. Rather, the
new economy, old economy, and other. It is difficult to trend has been gradual and is evident mostly in the devel-
classify all industries as either old or new economy. After oped markets. As noted earlier, country factors in these
all, technological advances find their way into all corners markets, while still important, have declined in both abso-
of the economy. Instead, we pick only the most repre- lute and relative terms over the last 12 years.
sentative members of each type, classifying the remaining As markets integrate, we expect to see an increase in
industries as “other.” We use principal components anal- the correlations of their returns. Using this measure, we
ysis to formalize the separation of individual industries into examine the degree of integration that occurred within three
the three categories. regions since 1994: continental Europe, developed markets
In the end, the new economy basket consists of the ex-continental Europe, and the emerging markets.
Electrical, Information Technology, Media, and Telecom Exhibit 7 shows the average pairwise correlation
industries, while the old economy basket is Construction, between pure country indexes, constructed as a sum of
Materials, Heavy Manufacturing, Alcohol and Tobacco, the world equity factor and a country factor. These pure
Food, Textiles, Transportation, and Automobile industries. indexes capture return to each market net of its industry
(See the appendix for details on the classification method- and style biases.12
ology.)10 The three regions differ substantially in their degree
To assess the contribution of the new economy of integration. In continental Europe, the average corre-
industries, we decompose the second term in Equation lation between countries has increased from 35% to a lit-
(7) as follows: tle over 70% in the last ten years. The significant increase
Old Economy
New Economy
Other
We wondered whether by focusing on
6
Cross term the average correlation in the emerging mar-
kets we had missed increases in integration
5 within certain blocks of those countries. To
investigate this, we examine the South Amer-
ican and the Asian markets separately.13
4
The results are consistent with the find-
ings above. Over the period January 1995 to
3 January 2004, the average correlation among
South American markets increased from 13%
to 22%, while that of Asian markets increased
2
from 19% to 28%.
1 SUMMARY
Baca, Sean, Brian Garbe, and Richard Weiss. “The Rise of Sec-
tor Effects in Major Equity Markets.” Financial Analysts Jour- To order reprints of this article, please contact Ajani Malik at
nal, vol. 56 (2000). amalik@iijournals.com or 212-224-3205.