Changing Risks in Global Equity Portfolios

Given recent changes in sector and style risk and in manager betting behavior in the global equity markets, we analyzed the relative importance of the major active-risk drivers and the implications of their relative importance for global multimanager portfolio construction. Using cross-sectional regressions and multimanager portfolio simulations, we found that the effect of style and sector bets on active manager risk increased after 1998 and that using style-balanced portfolios could have substantially reduced active risk during the 1998–2002 period. Most of the risk reduction, however, would have come from the diversification of stock/sector selection risk, because growth and value managers make different bets on certain sectors. Common bets on major countries, such as Japan or the United States, persisted during this period, but their importance decreased because of smaller benchmark-relative bets and country risk. In light of the changes, using multiple risk-control strategies to construct multimanager portfolios may be an effective way to thrive in different market environments. In the early to mid-1990s, country factors were the dominant drivers of risk and return for global equity portfolios. Thus, the key to controlling this risk was using low-country-bet managers or overlaying portfolios with country futures. Since this period, however, the importance of sector and style risk has increased and managers have changed their bets, which suggests that the prior focus on country risk should be reconsidered. To this end, we investigated changes in the relative importance of active risk drivers for global equity portfolios and the implications of their importance for constructing global multimanager portfolios.Manager data come from the Russell/Mellon Company’s InterWorld and RepEAFE equity universes with, respectively, the MSCI World and MSCI Europe/Australasia/Far East indexes as benchmarks. Using these data for the 1990–2002 period, we show that since 1998, the country factor has not exerted a dominant influence on the active risk of EAFE and World portfolios; instead, sector and style (value versus growth) risk have become increasingly important. The primary causes of the shift in active risk were (1) a gradual reduction in managers’ country bets, (2) the increasing significance of sector and style risk relative to country risk, and (3) the rising influence of investment style on manager sector/style views. These findings suggest that investors should diversify portfolios among country, sector, and style (and market capitalization) risk rather than emphasizing only one factor.To help investors cope with the rising influence of sector and style risk on active risk, we investigated various strategies for constructing global equity portfolios. We found a potential diversification benefit from combining growth and value managers. The two groups have had disparate views on certain sectors (particularly the technology sector and the materials and processing sector), but their country views have been highly correlated, primarily because of their common history of betting against Japan. Using multimanager portfolio simulations, we demonstrate that diversifying according to manager style could have substantially lowered active risk after 1998, when sector and style risk was rising. Much of the reduction in risk came from stock/sector selection rather than country allocation, suggesting that the style-balanced strategy diversified away style risk as well as some sector risk. Our simulation results affirm the benefit of balancing manager style in portfolio construction.