Abstract
Since Roll (The Journal of Finance 47(1):3–41, 1992) and Heston and Rouwenhorst (Journal of Financial Economics 36:3–27, 1994), there has been a debate whether country factors in international stock returns are typically more variable than sector factors. The addition of emerging markets (EMs) does boost the ratio of country-factor variance relative to industry-factor variance: these markets have a higher variability, but are also less related to global factors. Investigating to what extent this phenomenon can be tracked down to the impact of adding more small firms, we find the following. (1) Small firms do have higher volatility, but only after controlling for country and sector affiliation. (2) Small firms do have weaker sector affinity, as expected. (3) Small firms unexpectedly have weaker local-market sensitivities than large firms. Facts (2) and (3) mean that adding more small firms to the data base has a diversifying effect on both the sector- and country-factor variance; while the impact on sector variance is larger, the net effect turns out to be tiny. (4) Adding emerging markets has a very marked impact on the variance ratio. In fact, the addition of small stocks to the sample hardly dents the effect of adding EMs. Thus, the role of EMs cannot be reduced to just a small-firm phenomenon.
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Notes
The effect of local monetary and fiscal policies, differences in institutional and legal regimes and regional economic shocks.
The effect of sector economic shocks.
Related relevant work includes Beckers et al. (1996), Brooks and Del Negro (2006), Forbes and Chinn (2004) and Griffin and Karolyi (1998). Methodologically less comparable work includes Beckers et al. (1992), Brookes (2000), Ehling and Ramos (2006), Ramos (2003), Roll (1992) and Sharaiha et al. (2003, 2004).
Small-caps are not covered by Thomson Datastream’s (TDS) market lists, the dominant source of international data, and researchers often prefer not to waste time on penny stocks and are not eager to clean up TDS’s untidy “research” or “dead stocks” files (see Ince and Porter 2006, for more about TDS data problems).
The Center for Research On Security Prices files, set up by the Chicago GSB, has been a prime source of (high-quality) data. The coverage is confined to the US, though.
The mean conditional exposure numbers, t’s, and R 2s are not shown. Full details are available on request.
Recall that the marginal contribution of an asset to a portfolio’s variance is the asset’s covariance with the entire portfolio, in which the covariances with the hundreds of other assets dominate.
The average country-specific and sector-specific volatility both go down compared to the world factor volatility, consistent with G7 countries being more diversified, more integrated into the world economy and more similar to each other.
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Acknowledgements
The authors thank Marno Verbeek, Geert Dhaene, Constant Beckers, Stefan Duchateau, Bruno Solnik, Koen Inghelbrecht and seminar participants at the Katholieke Universiteit Leuven, the Hogeschool-Universiteit Brussel, the French Finance Association (Paris, 2005), the Financial Management Association (Stockholm, 2006) and the International Federation of Scholarly Associations of Management (Berlin, 2006) for helpful discussions and valuable comments on earlier drafts of this article. Lieven De Moor gratefully acknowledges financial support from the Fund for Scientific Research, Flanders, Belgium
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An early and wider ranging precursor paper by the same authors, entitled Country and Sector Effects in International Stock Returns Revisited, appeared as FETEW Research Report AFI0615, KU Leuven, 32 p. Comments and suggestions from an anonymous referee and the Editor of this journal have been very useful.
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De Moor, L., Sercu, P. Country v sector effects in equity returns and the roles of geographical and firm-size coverage. Small Bus Econ 35, 433–448 (2010). https://doi.org/10.1007/s11187-008-9170-6
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DOI: https://doi.org/10.1007/s11187-008-9170-6