Sector Effects in Developed vs. Emerging Markets

This examination of developed and emerging markets suggests that toward the end of the 20th century, sector effects caught up with country effects in the developed markets of the world, as a result of rising sector effects rather than declining country effects. For emerging markets, however, country effects have remained the dominant influence relative to sector effects, although the importance of country effects has been on a steady decline. These results confirm that international equity managers should emphasize sector-based approaches when investing in the developed countries but should continue country-based allocation strategies in emerging markets.A fundamental starting point for global equity managers when applying a top-down approach to their investing has been the selection of a country. Since 2000, however, the relative importance of the country factor has been challenged by several researchers, who concluded that the relative importance of industrial factors has exceeded that of country factors. Two questions of great interest are whether this apparent shift is ongoing and whether it applies to all markets. If the shift varies by country (e.g., between developed markets and emerging markets), investment managers who assume that all markets behave in a similar way could find their strategies becoming ineffective when they widen their horizons from developed to emerging markets. To study the two questions, we collected all monthly returns of market capitalization–weighted equity indices that are available in the Datastream database for 23 countries classified as developed markets and 26 countries classified as emerging markets. For analyzing the influence of sectors, we used 10 sector indices (with sector classifications as defined by the Financial Times Actuaries Index). The sample period is January 1994 through May 2005.We applied a factor model used by previous researchers that decomposes an individual equity return index into three parts—a constant, a country effect, and a sector effect. We used pure factor variance and mean absolute deviation (MAD) to measure the pure country effects and pure sector effects.Our results indicate that the relative importance of the sector and country factors is different in the developed markets from their relative importance in the emerging markets. For the developed markets, the sector and country effects have been competing with each other in relative importance since the turn of the 21st century. In line with recent research, our findings for the developed markets suggest that (when measured by the variance method) sector effects approach the same level as country effects or (when measured by the MAD method) exceed country effects. Note that both effects as measured by both methods declined steady in the new century, with a markedly smaller difference between them. The reason could be increased financial integration across countries. We found that the ascendancy of sector effects is a consequence of a rise in sector effects rather than a fall in country effects. Global equity managers cannot afford to ignore the sector factor in allocating capital in the developed markets. Managers should keep their eyes on the sector factors and consider the possibility of sector allocation all the time. Additionally, we provide new explanations of the recent rise in sector effects in the developed markets. First, we argue that the steady sector increase was a general trend in the world market, not purely the impact of the TMT (telecommunications/media/technology) bubble. The sharp increase of the sector effect near the end of 2000 was, however, mainly a result of the TMT bubble, and the sector effect has declined from that peak. Previous literature, because of the sample periods, could only suggest the temporary nature of the sharp TMT sector increase. As far as we know, our study presents the first complete picture of the bubble’s effect on the sector factor.In the emerging markets, we observed much higher pure variance and MAD for the country factor than for the sector factor, indicating that for the emerging markets, a diversification strategy based on country remains more important than a sector-based strategy. Global equity managers should continue to use a strategy of diversification by country.Nevertheless, we also observed a slight rise in sector effects in the emerging markets. Therefore, we warn that the dominance of country factors in the emerging markets may diminish in the future.