Sectoral equity returns in the Euro region: Is there any room for reducing portfolio risk?

Economic integration among Euro members has important consequences for factors driving asset pricing and asset trading within the financial markets. In particular, since the start of the EMU, cross-country equity index correlations in the region have shown upward trends and domestic investors have allocated their portfolios mostly within the region. We study the impact of these recent structural changes on the Euro-wide sectoral equity indices. We model the return and volatility of the Euro sector equity indices between 1992 and 2007. We find that aggregate world equity or global sector equity indices have not affected the sector equity indices since the beginning of the Euro. The aggregate Euro equity index, however, still affects most of the sector equity indices, even though its effect declines remarkably for some sectors. In particular, we find that financial sector equity indices (financial services, insurance, and banking) are being increasingly affected by the aggregate Euro equity index fluctuations observed after the start of the EMU. However, some "basic industry sector" indices, including basic resources, food and beverages, health-care, retail services, oil and gas, and utility become less dependent on the aggregate Euro equity index since the start of the EMU, suggesting that diversification across these sectors within the region would be much more effective for reducing portfolio risk.Research highlights [right triangle, filled] Euro equity bias and the integration of Euro equity markets limits the diversification opportunities. [right triangle, filled] Diversification across Euro sectoral equity indices is more preferable than diversification of the portfolio across Euro nation indices after the start of The Euro. [right triangle, filled] Some sectors are less sensitive to the local shocks in the Euro area. Diversification across these "less sensitive sectors" leads better portfolios according to MPT.