Country, Industry, and Risk Factor
Loadings in Portfolio Management
It is illegal to make unauthorized copies of this article, forward to an unauthorized user or to post electronically without Publisher permission.
Country effects declining in importance; industry effects growing.
The Journal of Portfolio Management 2002.28.4:70-79. Downloaded from www.iijournals.com by Tufts University on 12/09/15.
Jean-François L’Her, Oumar Sy, and Mohamed Yassine Tnani
JEAN-FRANÇOIS L’HER is
a research advisor at Caisse
de dépôt et placement du
Québec in Montreal (Quebec
H3A 3C7).
jlher@cdp.ca
OUMAR SY is an analyst at
Caisse de dépôt et placement
du Québec in Montreal (Que-
bec H3A 3C7).
osy@cdp.ca
MOHAMED YASSINE TNANI
is an analyst at Caisse de dépôt
et placement du Québec in
Montreal (Quebec H3A 3C7).
mtnani@cdp.ca
70 COUNTRY, INDUSTRY, AND RISK FACTOR LOADINGS IN PORTFOLIO MANAGEMENT
global portfolio built using a top-down
A approach may usually be allocated on the basis
of a country or industry dimension. The
choice of dimension will depend on whether
the portfolio manager believes that returns are governed
primarily by country or by industry effects.
Heston and Rouwenhorst [1994, 1995], Griffin
and Karolyi [1998], and Rouwenhorst [1999] show that
country effects, on average, dominated industry effects
during the 1975-1998 period. Baca, Garbe, and Weiss
[2000], Cavaglia, Brightman, and Aked [2000], Kerneis
and Williams [2000], and Hopkins and Miller [2001],
however, point out that industry effects have grown so
markedly in importance that they have superseded coun-
try effects in the variation of international stock returns.
These trends in country and industry effects can be
explained largely by ongoing capital market integration.
The past few years have witnessed increased correlations
between country returns (see Freimann [1998]). This phe-
nomenon is attributable to a number of structural changes:
reduction in international barriers to investment; major
developments in information technologies that have
improved access to global information; an unprecedented
wave of global mergers and takeovers; a move toward pri-
vatization; and the integration of geographic zones, espe-
cially in Europe. Globalization of the world economy has
likely diminished the benefits of diversification across
countries in favor of diversification across industries.
We use a two-step procedure to reexamine the rel-
ative importance of country and industry effects in the
SUMMER 2002
 variation of international stock returns. The first step,
which is estimation of the model, follows Heston and
Rouwenhorst [1994, 1995] and Griffin and Karolyi
[1998].1
In the second step, unlike previous authors, we sep-
arate the cross-sectional variance of monthly interna-
tional stock returns into different effects, and then study
the evolution of each component. Our work differs from
other research in two key areas: the data set used, and,
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more important, the inclusion of global risk factor load-
ings in the analysis.
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Our data, taken from Standard & Poor’s Compustat
Global Vantage, cover 20 developed countries and 11
broad industries, and span the period July 1989 through
December 2000. An advantage of our data set is that it
covers a great number of stocks (7,348 firms), making it
possible to obtain more cross-sectional variance in the size
characteristics of firms.
The more distinctive element of the research per-
tains to inclusion of global risk factor loadings in the
model. Studies examining the relative importance of
country and industry effects as a source of variation in
international stock returns have assumed identical global
risk exposure for each stock. Yet authors have demon-
strated the presence of global premiums related to size
(Heston, Rouwenhorst, and Wessels [1995]), book-to-
market (Arshanapalli, Coggin, and Doukas [1998], Fama
and French [1998]), and price momentum (Rouwen-
horst [1998]) (see Liew and Vassalou [2000] for evidence
on these three premiums). We use a global four-factor
pricing model to control for differences in global risk fac-
tor loadings between international stocks.
Using a country/industry dummy variable frame-
work, we show that country effects dominated industry
effects during the 1992-2000 sample period, corroborat-
ing the findings of Heston and Rouwenhorst [1994,
1995] and Griffin and Karolyi [1998]. Consequently,
country diversification was on average more efficient than
industry diversification during the nineties. Like Baca,
Garbe, and Weiss [2000], Cavaglia, Brightman, and Aked
[2000], Kerneis and Williams [2000], and Hopkins and
Miller [2001], we also note that industry effects have
gained in importance. The ongoing trend toward inte-
gration has reduced the benefits of country diversification;
consequently, industry-oriented approaches to global
management could be as effective as country-oriented
approaches in the future.
Top-down approaches to global equity portfolio
allocation should consider both the country and indus-
SUMMER 2002
try dimensions. Carrieri, Errunza, and Sarkissian [2000,
p. 26] conclude that: “In other words, ... investors should
use both cross-country and cross-industry diversification
as a way to improve portfolio performance” (emphasis in
the original).
More important, the globalization of the economy
has also strengthened the role of global risk factors as a
source of variation in international stock returns. While
the main trends of the country/industry analysis remain
the same, global risk effects became stronger during the
sample period, and are currently more significant than
country and industry effects. Consequently, global man-
agers should consider exposure to these global risk fac-
tors when they construct their portfolios.
DATA
Our data set, extracted from the Standard & Poor’s
Compustat Global Vantage database, spans the period July
1989–December 2000, and covers a total of 20 countries
and 11 industries.2 The set covers 7,348 stocks, more
than other studies, and includes small-capitalization stocks,
which enables us to obtain more cross-sectional variance
in size factor loadings.3
The sample includes all firms for which information
as follows is available: dollar-denominated total return,
market capitalization, book-to-market ratio, and a descrip-
tion of the industry and country affiliation.4 Exhibit 1 pro-
vides descriptive statistics on the returns observed from
January 1992 through December 2000.
Panel A gives the main return characteristics by
country. On average, we examine 367 firms per country,
but the number of firms and industries varies by coun-
try. The United States is by far the most represented, with
almost one-quarter of the firms covered (1,757 firms)
followed by Japan (1,682 firms), and the United Kingdom
(908 firms).
With the exception of Finland, the most volatile
index returns are observed in the Far East countries. Fin-
land (4.04% per month) and Sweden (2.09% per month)
are the countries with the highest cap-weighted average
return. Austria and Japan recorded the poorest average
returns (respectively, –0.12% and 0.16% per month). The
low tracking error between the index returns of the
G-7 countries and their corresponding MSCI country
index returns is a guarantee of the quality of our data.
Panel B provides the main return characteristics by
industry. The number of firms in industries varies from
1,837 for consumer cyclicals to 62 for communication ser-
THE JOURNAL OF PORTFOLIO MANAGEMENT 71
 EXHIBIT 1
Country, Industry, and Global Returns January 1992–December 2000

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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Finland 52 0.57 4.04 11.55

France 382 4.28 1.13 4.76
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Germany 370 5.33 0.90 4.73

Hong Kong 144 1.85 1.44 9.77
Italy 152 2.25 0.81 7.06
Japan 1682 18.82 0.16 6.82
Malaysia 363 0.69 0.82 12.00
Netherlands 131 1.96 1.68 5.06
Norway 66 0.24 0.87 6.60
Singapore 180 0.51 0.99 10.17
Spain 93 0.96 1.16 6.15
Sweden 121 0.85 2.09 7.83
Switzerland 137 1.97 1.49 4.58
U.K. 908 8.75 1.02 4.07
U.S. 1757 46.13 1.35 3.90
Mean 367 5.00 1.17 6.47
Median 148 1.63 1.01 5.32

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
month) and health care (1.29% per month) posted the best
returns; basic materials (0.56% per month) and consumer
cyclicals (0.57% per month) posted the lowest returns. The
technology returns were the most volatile (6.69% standard
deviation of monthly returns). At the other extreme, util-
ities returns registered a standard deviation of only 2.84%.
Panel C shows the average return and standard devi-
ation of each of the four global risk factors: the global mar-
wise, Iij is a dummy variable that equals 1 when firm j
belongs to industry i (i = 1, …, 11) and 0 otherwise, and
ejt is the error term.
To solve the identification problem induced by
dummy variables and to facilitate interpretation of the
coefficients, we impose the same restrictions as Heston and
Rouwenhorst [1994, 1995] and Griffin and Karolyi [1998]:
20

∑γ φ =0 (2-A)
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ket (Rw ), and three global zero net investment portfolios ct ct −1

c =1
constructed on the basis of firm market capitalization
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(small minus big: SMBw ), firm book-to-market (high 11

minus low: HMLw ), and stock price momentum (win- ∑λ ϕ

i =1
it it −1 =0 (2-B)
ners minus losers: WMLw ).
The global market posted a return of 1% per month
(t-statistic 2.80). The global market premium was 0.61% where φct-1 and ϕit-1 are the weights of country c and
per month and significantly different from zero only at the industry i in the world portfolio at the beginning of the
10% level. SMBw, HMLw, and WMLw posted monthly month. Given these restrictions, the parameter αwt can be
returns of 0.21%, -0.08%, and 0.76%, respectively. WMLw interpreted as the cap-weighted average return of the
is significant at the 1% level (t-statistic 2.20), while SMBw world portfolio at time t, and coefficients γct and λit stand
and HMLw are not significant.5 for the “pure” bet at time t on country c without indus-
See the appendix for details on the construction of try bias and the “pure” bet on industry i at time t with-
factors. out country bias.
In the second step, the cross-sectional variance of the
METHODOLOGY international stock returns is segmented in order to iden-
tify the proportion of the variance attributable to stock-
The first methodology presented is based on coun- specific (S/T ), country (C/T ), and industry (I/T )
try and industry fixed effects, and the second integrates effects. This allows us to determine for each month com-
country and industry fixed effects with global factor ponents that best explain the cross-sectional variance of
loadings. international stock returns. The three components are cal-
culated as follows:
Country and Industry Fixed Effects
 20 
We use a two-step procedure to differentiate between Var  ∑γˆ ct Ccj 
St Var (e jt ) Ct  c=1 
the variance of international stock returns due to coun- = =
try effects and the variance attributable to industry effects. Tt Tt Tt Tt
The first step, which separates country-related perfor-  11 
mance from industry-related performance, is similar to the Var  ∑λˆit Iij 
It  i=1 
dummy variable regression framework used in Heston and =
Rouwenhorst [1994, 1995] and Griffin and Karolyi Tt Tt (3)
[1998]:6

20 11 where, Tt = St + Ct + It stands for the total effects.7

Rjt = α wt + ∑ γ ct Ccj + ∑ λit Iij + e jt (1)
c =1 i =1
Fixed Effects and Global Risk Loadings

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-

SUMMER 2002 THE JOURNAL OF PORTFOLIO MANAGEMENT 73

 ine the relative importance of loadings on the four global EXHIBIT 2
risk factors and country/industry dummy variables as a Evolution of Stock-Specific, Country,
source of variation in international stock returns. We use and Industry Effects
a four-factor global pricing model to estimate the factor
loadings for each stock j ( βˆ wmjt , βˆ wsjt , βˆ whjt , and βˆ wwjt ) and Year Stock-Specific Country Industry
1992 67.65 26.81 5.54
then estimate this model monthly:8
1993 68.11 25.35 6.54
1994 72.51 21.26 6.23
Rjt = α ' wt + α wmt βˆ wmjt + α wst βˆ wsjt + 1995 75.80 17.99 6.22
1996 78.94 14.70 6.36
20
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α wht βˆ whjt + α wwt βˆ wwjt + ∑γ ct Ccj + 1997 73.32 19.02 7.67

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c =1 1998 77.30 13.72 8.98

11
∑λ I
i =1
it ij + e jt
where α'wt is the world return for the period t that is not
explained by the four global risk factors, and the parame-
ters αwmt, αwst, αwht, and αwwt represent the global risk pre-
miums associated with each factor loading.
Equation (4) makes it possible to compare country and
industry effects while controlling for differences in expo-
sure of international stock returns to the four global sources
of risk. Restrictions (2-A) and (2-B) are also imposed in
Equation (4).
As in the country/industry analysis, the second step
consists of subdividing the cross-sectional variance of
international stock returns into four components: the
stock-specific (S/T ), country (C/T ), industry (I/T ), and
global risk factor loading (G/T ) components. The first
three components are calculated using the procedure
above (except T), while the fourth, which is the variance
explained by global risk factor loadings, is equal to:
 
Var  ∑ αˆ wkt βˆ wkjt 
Gt  k = m, s, b and w  (5)
= forming a portfolio of non-perfectly correlated securities.
Tt Tt
where Tt = St + Ct + It + Gt represents the total effects.
To assess the relative importance of each individual
global factor loading, we separate the (Gt/Tt) variable into
four components related to the exposure to global mar-
ket (Rw/T ), size (SMBw/T ), book-to-market (HMLw/T ),
and return momentum (WMLw/T ).9
RESULTS
We present the results of the methodology that con-
siders solely fixed country and industry effects first. Next,
1999 75.35 9.75 14.90
(4) 2000 74.76 7.85 17.39
Mean 73.75 17.38 8.87
Median 74.76 17.99 6.54
Each effect is measured by the average annual proportion of the variance that
is due to the stock-specific, country, and industry components [Equation (3)].
Proportions expressed in percentages.
we analyze the results obtained when global factor load-
ings are introduced. We then investigate the robustness of
the results using a different industry classification, fewer
countries, and only large market capitalization firms.
Country and Industry Fixed Effects
Exhibit 2 shows the contribution of each of the
three effects (specific, country, and industry) to the cross-
sectional variance of international stock returns for each
year studied. With on average 73.75% of the total effects,
the stock-specific component largely dominates the other
effects. This result confirms the relevance of investing in
a portfolio rather than in a single stock, given that the
stock-specific component can be significantly reduced by
The remainder of the international stock return
cross-sectional variance is explained by country and indus-
try effects. For the total sample period, country effects
explain on average 17.38% of the return variance, domi-
nating the 8.87% explained by industry effects. This result
is consistent with the conclusions of Heston and Rouwen-
horst [1994, 1995] and Griffin and Karolyi [1998].
There are significant portfolio management impli-
cations to be drawn from the dominance of country
effects over industry effects in the variation of international
stock returns. The most important is that diversification
across countries has been more effective than diversifica-
tion across industries during this period. As Heston and

74 COUNTRY, INDUSTRY, AND RISK FACTOR LOADINGS IN PORTFOLIO MANAGEMENT SUMMER 2002
 Rouwenhorst conclude: “There are substantial benefits to
international diversification beyond the amounts
attributable to industrial or currency diversification”
[1994, p. 26].
This result nevertheless overshadows the evolution
of country and industry effects. There has been a signif-
icant shift from country to industry influences in recent
years. Indeed, the relative importance of country effects
declined significantly during the period studied, dropping
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tion included in this panel somewhat resembles that of
Exhibit 2, except that it introduces the differences in
global risk exposure as a source of variation in interna-
tional stock returns.
The stock-specific component remains very high at
72.75% on average (a slight decline from a level of 73.75%
with fixed effects only). For the entire sample period,
country effects on average continue to dominate indus-
try effects (14.77% versus 7.64%). While the fixed effects

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
has continued to increase. The portion of the global return
variance accounted for by industries increased from 5.54%
in 1992 to 17.39% in 2000. As a result, industry effects
exceeded country effects as a source of variation in cross-
sectional returns for 1999 and 2000. During these two
years, diversification across industries would have been
more advantageous than diversification across countries.
This result is consistent with results in Baca, Garbe,
and Weiss [2000], Cavaglia, Brightman, and Aked [2000],
and Hopkins and Miller [2001]. Hopkins and Miller
emphasize that the increase in industry effects is indica-
tive either of more extreme sector returns around the
global average or of the rising importance of sectors as
drivers (information technology, energy, and utilities).
Fixed Effects and Global Factor Loadings
Exhibit 3, Panel A, presents the results of estimation
of Equation (4), which combines both fixed country/indus-
try effects and global risk factor loadings. The informa-
explain on average 4.83% of the return variance.
As in the analysis based solely on country and indus-
try fixed effects, the relative importance of country effects
in the variation of international stock returns has drasti-
cally declined (from 22.07% in 1992 to 8.20% in 2000).
Industry effects have gained concomitantly in impor-
tance; they represented 4.62% of the cross-sectional vari-
ance in 1992 versus 10.71% in 2000. Since 1999, industry
effects have even surpassed country effects.
The most interesting result pertains to global factor
loadings. From 1992 to 2000, the global factor loadings
as a source of variation in international stock returns have
grown so dramatically—increasing from 6.20% in 1992 to
11.51% in 2000—that global factor loadings outweighed
country and industry effects in 2000. As the global factor
loading effects are non-diversifiable, we can conclude that
benefits of international diversification have been signifi-
cantly declining in more recent years, particularly in 2000.
Exhibit 3, Panel B, shows the breakdown of the
global factor loadings into four components. The corre-
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

SUMMER 2002 THE JOURNAL OF PORTFOLIO MANAGEMENT 75

 the most important global risk exposure is that of the EXHIBIT 4
global market, with 1.46% of the total variance followed Evolution of Stock-Specific, Country, Industry,
by SMB, HML, and WML with 1.12%, 1.06%, and 0.96% and Global Risk Effects—Sensitivity Analysis
of the variance, respectively. The increase of the relative Year Stock-Specific Country Industry Global
importance of global factor loadings as a source of vari- Panel A. 20 Countries and 21 Subindustries
ation in international stock returns is driven mainly by the 1992 66.00 22.12 5.71 6.18
increase in the percentage of variance explained by the 1993 65.77 21.89 7.86 4.48
global market and size loadings (from 0.77% and 0.96% 1994 71.19 18.74 6.98 3.08
in 1992 to 2.60% and 2.61% in 2000). The percentage 1995 73.92 15.61 6.96 3.51
1996 76.75 13.84 7.35 2.07
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explained by the book-to-market loadings increased by

only 0.1% for the same period, while that explained by 1997 70.71 16.72 8.50 4.07
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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,
and global risk effects when only the top 25% of firms in
terms of market capitalization are considered. Kerneis and
Williams [2000] have shown that the large-cap stocks have
a more sensitivity to global industry factors than the total
universe. Our earlier results are not materially changed by
restricting the total universe to large-cap stocks.
Like Kerneis and Williams [2000], we note that the
stock-specific components have less impact in the large-
It is illegal to make unauthorized copies of this article, forward to an unauthorized user or to post electronically without Publisher permission.
cap universe. This decline of the stock-specific component
results in heightened industry effects (from 7.64% to
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8.83%), country effects (from 14.77% to 16.79%), and
global risk effects (from 4.83% to 6.37%). Even for large-
cap companies, country effects have on average dominated
industry effects during the period of 1992-2000. Indus-
try and global risk effects, however, are still more appar-
ent than country effects in 1999 and 2000.
SUMMARY
We have compared the relative importance of coun-
try, industry, and global factor loading effects in explain-
ing the variation in international stock returns during the
1990s (from January 1992 through December 2000). We
factor a risk dimension into the analysis, making it pos-
sible to identify the portion of the variation in interna-
tional returns attributable to global risk levels incurred.
If we consider the country and industry dimen-
sions exclusively, on average country effects dominated
industry effects over the entire period. Consequently,
diversification across countries was on average more effi-
cient than diversification across industries.
Country effects declined significantly during the
nineties, however. The portion of the return variance
attributable to country effects declined from 26.81% in
1992 to only 7.85% in 2000, a decrease of 70.72%. Indus-
try effects came to play a greater role in explaining the vari-
ance of international stock market returns, shifting from
5.54% in 1992 to 17.39% in 2000; they dominated coun-
try effects in both 1999 and 2000. Thus, ongoing global
integration has made industry-oriented approaches to global
investment as effective as country-oriented approaches.
By implication, global management strategies should
pay greater attention to the benefits of industrial diversi-
fication. As country effects remain more than trivial,
however, asset classes should be defined using both coun-
try and industry dimensions to maximize the benefits of
diversification.
Furthermore, globalization has strengthened the
SUMMER 2002
role of global risk factors in explaining co-movements in
international stock returns. The extent of stock market
returns explained by differences in exposure to global
risk factors rose considerably during the period covered.
Global risk effects dominated both country and industry
effects in 2000, with 11.51% versus 10.71% for industry
effects and 8.20% for country effects. Global management
strategists could consequently delineate asset classes on the
basis of their global risk factor loadings.
The trend toward globalization is instrumental in
determining the relative importance of country, industry,
and global risk effects. The structural changes in global
economies probably explain why in the last decade coun-
try effects have been losing ground in favor of industry
and global risk effects. Given that these three effects have
become equally important in the recent period, it is best
to consider all three dimensions—country, industry, and
global risk factors—in constructing portfolios.
APPENDIX
Construction of Global Risk Factors
As we focus on both country and industry effects, we do
not compute global factors as weighted averages of country (see
Fama and French [1998]) or industry factors. Instead, we com-
pute them regardless of countries or industries.
For each month t from July of year y – 1 to June of year
y, we rank stocks based on size and book-to-market ratio of June
y – 1 and their previous performance between t – 12 and t –
1. We perform independent sorts beginning in July 1990 to cre-
ate SMBw, HMLw, and WMLw. We use 50% break points for
size, and 30% and 70% break points for book-to-market and
prior performance.
Following Fama and French [1993], we form six global
value-weight portfolios, S/L, S/M, S/H, B/L, B/M, and B/H,
as the intersection of size and book-to-market groups. We fol-
low the same procedure for prior performance as for book-to-
market; that is we form six global value-weight portfolios,
S/L, S/M, S/W, B/L, B/M, and B/W, as the intersection of
size and prior performance groups. SMBw, HMLw, and WMLw
are as follows: SMBw = [(S/L – B/L) + (S/M – B/M) + (S/H
– B/H)]/3, HMLw = [(S/H – S/L) + (B/H – B/L)]/2, and
WMLw = [(S/W – S/L) + (B/W – B/L)]/2.
Consequently, our methodology can be compared directly
to neither that of Liew and Vassalou [2000], who use three
sequential sorts, nor to that of Arshanapalli, Coggin, and Doukas
[1998], who use 70% and 30% break points for SMB and con-
struct HML by selecting the highest book-to-price stocks until
half of the capitalization of each market is accumulated.
THE JOURNAL OF PORTFOLIO MANAGEMENT 77

ENDNOTES
The authors thank for insightful comments Stéphanie
Desrosiers, Richard Guay, Walid Hached, and Aurel Wisse, and
for helpful translation assistance Karen Sherman.
1
This dummy variable regression framework was first
developed by Solnik and de Freitas [1988] and Grinold, Rudd,
and Stefek [1989]. It was later used by Beckers et al. [1992],
Drummen and Zimmerman [1992], Roll [1992], and Heston
and Rouwenhorst [1994], among others.
It is illegal to make unauthorized copies of this article, forward to an unauthorized user or to post electronically without Publisher permission.
2
The countries are Canada, the United States, Malaysia,
and 17 of the 20 countries in the EAFE index. Like Cavaglia,
The Journal of Portfolio Management 2002.28.4:70-79. Downloaded from www.iijournals.com by Tufts University on 12/09/15.
Brightman, and Aked [2000], we focus only on developed
countries that are more economically integrated in order to
avoid a possible country bias effect related to emerging coun-
tries. The Compustat database defines 12 industries. There are
few firms and only four countries in the biotechnology sector,
so we group it with the information technology sector, result-
ing in 11 industries. To analyze the sensitivity of results to the
definition of industries, we use the first two digits of the Com-
pustat 103-sector additional classification, leading to a classifi-
cation of 21 subindustries.
3
On the whole, 14,452 securities were extracted from the
database. We dropped 3,534 securities that are not classified
within an industry, and then subsequently eliminated 3,570 firms
lacking sufficient data. This process resulted in a sample of
7,348 firms, of which 1.21% are inactive.
Heston and Rouwenhorst [1994] use 829 firms; Griffin
and Karolyi [1998] about 2,600. More recently, Baca, Garbe,
and Weiss [2000] and Cavaglia, Brightman, and Aked [2000]
examine 3,212 and 2,645 firms, respectively.
4
With respect to dollar returns, Heston and Rouwenhorst
emphasize that “most of the variance of the country effect
cannot be explained by currency movements” [1994, p. 24].
5
By comparison, Liew and Vassalou [2000] report in ten
major markets over 1978-1996 both economically and statis-
tically significant premiums. Furthermore, because growth
stocks posted a relatively high return in the 1992-2000 period,
the HMLw premium is much lower than the ones reported by
Fama and French [1998] and Arshanapalli, Coggin, and Doukas
[1998] over the 1975-1995 period.
6
As in Griffin and Karolyi [1998], in order to take into
consideration the relative impact of market capitalization, we
use the weighted least squares method rather than the ordinary
least squares method.
7
To calculate the cross-sectional variance, each stock is
assigned a weight equal to its capitalization weight in the world
portfolio at the beginning of the month. Note that the decom-
position ignores the covariance between the fixed industry and
country effects. The proportion of the variance attributable to
specific effects is therefore not perfectly equal to 1 – R2. This
approximation is reasonable insofar as covariance between fixed
industry and country effects is not very different from zero.
78 COUNTRY, INDUSTRY, AND RISK FACTOR LOADINGS IN PORTFOLIO MANAGEMENT
8
The loadings on the global market and the three zero-
net investment portfolios are estimated after June 1993 using
36-month moving windows (between t – 37 and t – 1) and
imposing the restriction that 24 months of data be available in
each security window. For the first months, however, we use
shorter moving windows. For better comparison, we estimate
both model specifications from 1992 through 2000.
9
These components are calculated using the equations
( ) ( )
ˆ ˆ
Rwt Var αˆ wmt β wmjt SMBwt Var αˆ wst β wsjt
= , =
Tt Tt Tt Tt
( ) ( )
ˆ ˆ
HMLwt Var αˆ wbt β wbjt WMLwt Var αˆ wwt β wwjt
= , and =
Tt Tt Tt Tt
The sum of these individual components is not equal to
the global factor loadings effect, Gt/Tt because this latter term
considers the covariances between these components.
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THE JOURNAL OF PORTFOLIO MANAGEMENT 79