Country Versus Industry Effects

Country Versus Industry Effects
by Mike Brooks

We are living in a world of increasing globalization. For many companies it is no longer sufficient to operate solely in their own domestic market. The relaxing of trade barriers and the advances of technology have acted as catalysts to this development.

In this new global market, the traditional view that a portfolio's country weighting is the key determinant of performance is weakening. Increasingly, industry weightings are becoming as important, or possibly even more so.

There are a number of reasons why this issue is of relevance to pension funds and their managers. Firstly, in establishing a fund's asset mix the aim is to provide a good risk/return trade-off by diversifying across the major asset classes. If industries are a more significant driver of performance than countries, then it is logical to focus on industry rather than country diversification. Secondly, the relative importance of these factors will influence the way in which investment managers structure their investment processes. In essence, this debate focuses on whether it makes more sense to value companies relative to others within the same country or relative to others within the same industry on a global basis.

The european debate
The industry versus country debate has been a particularly hot topic in European markets. Increasingly, economic integration and subsequent monetary union has resulted in weakening country effects and strengthening industry effects.

The global debate
Recent research1 suggests that global sectors are now more important than countries, particularly within developed markets and for larger companies.

While this is unlikely to lead to a wholesale shift in the way investment managers are structured, most managers are reviewing their practices. Many are coordinating sector research across regions for a number of the more global sectors2 while others have some global sector analysts in place.

The increasing need for communication between regional analysts may lead to a re-evaluation of where analysts are located. In the past there was some suggestion that having analysts on the ground in each region was favourable over basing everyone centrally and having them visit their regions on a frequent basis.3 Going forward, the benefits of one location are likely to receive greater recognition as the need to make global comparisons increases.

An interesting development in this area has been the launch of the Multinationals index series by FTSE last November. The Multinationals index is formed from companies that have greater than 30% of their sales revenues from outside their domestic region. The remainder of companies are placed in local ex-multinational indices. These local indices are (in theory) more responsive to the local economy and less dependent on global themes. By contrast, the Multinationals index is more influenced by global industry effects.

Impact on pension funds
One of the key issues facing pension funds is the need to improve the global diversification of investment policy. The major barrier to this development, in Canada in particular, is legislation. However, there are also cultural biases to domestic investing, often based around the belief that domestic equities represent a better hedge against real liabilities.

Assuming these barriers can be overcome, funds will have a free rein over investment policy. They will then be in a position to diversify across industries on a global basis. The trend towards global integration is gathering pace and an industry focus is likely to be the logical approach in the future.

1. Goldman Sachs, "Strategy focus--Sun, sand and sectors," (August 2000).
2. For example, at Baillie Gifford we formally co-ordinate research globally for 5 industries: Oils, Pharmaceuticals, Semiconductors, Telecomm Equipment and Telephone Networks.
3. It should be noted that numerous studies have found no significant performance differential between managers following these different approaches.

Mike Brooks is the Head of Portfolio Risk and Performance Analysis at Baillie Gifford in Glasgow, Scotland.

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