The Rise of Sector Effects in Major Equity Markets

Abstract

Historically, country effects have been dominant in explaining variations in global stock returns, even in the developed markets, and investors have segmented their allocations accordingly. We set out to investigate whether this situation still prevails. We found a significant shift in the relative importance of national and economic influences in the stock returns of the world's largest equity markets. In these markets, the impact of industrial sector effects is now roughly equal to that of country effects. In addition to supporting the notion of increasing global capital market integration, these findings suggest that country-based approaches to global investment management may be losing their effectiveness.

The degree to which global economies and capital markets are integrated plays a critical role in the relative importance of country and sector factors in global stock returns. Higher levels of integration blur national borders and diminish the significance of country factors vis-a-vis sectors. The historical dominance of country effects in explaining variations in global stock returns suggests that global capital markets have been relatively segmented. Accordingly, country-oriented strategies have been the most common approach to global equity management. Our research found evidence that country effects no longer dominate sector effects to the extent they have historically.

We studied 10 sector indexes within each of the seven largest global equity markets over a 20-year period. Using weighted least-squares regression, we decomposed the indexes for each country and sector into their respective global, country, and sector return components. The estimated coefficients from these regressions represent the “pure” return elements of each type of component. We examined the amount of variation explained by the time series of estimated country coefficients and sector coefficients to determine their relative importance.

Through the early 1990s, pure country returns exhibited roughly two to three times the variation of pure sector returns. The differential has narrowed dramatically, however, in the last several years. Since mid-1995, the ratio of average country coefficient variance to average sector coefficient variance has dropped from 3.10 to 1.23. The pronounced gap that existed earlier has been virtually eliminated.

For the most recent four-year period, the average pure country variance for the seven markets studied was 12.02 percent and the average pure sector variance was 9.76 percent, but the difference was not statistically significant even at a 50 percent confidence level. In other words, over the most recent four years, the importance of industrial sector classification has been roughly equal to that of country of domicile in the major equity markets.

We address the issue raised in previous studies that sector effects account for much less of the variation in country indexes than country effects do in sector indexes. We “reconstructed” the global country and sector indexes using the output from our weighted regression analysis. In contrast to the findings of previous studies, we found that neither of these cross-effects contributes meaningfully to global country or sector return variation.

Our findings indicate that over the past 20 years, the influence of country-based components on return variation has declined while the impact of sector-based components has either increased or remained relatively constant.

We discuss several factors that may explain the difference between our conclusions and those of previous studies. These factors include the time period studied, the specific countries included, the breadth of the industrial classification scheme, and the treatment of currencies. Studies that draw inferences from longer historical time periods than ours did or include less-developed markets will tend to find that country effects are more important than our study found. The use of broad industrial classifications, as in our study, may understate sector variation.

This study suggests that the world's major equity markets may be more integrated than was previously believed. For those practitioners whose current global strategies assume that national equity markets remain significantly segmented, these results represent both an admonition and an opportunity.

We are grateful to James Van Horne of Stanford University, Richard Boling of Sanwa Bank California, and G. Andrew Karolyi of Ohio State University for their many insightful comments.