International Diversification in the Euro-Zone: The Increasing Riskiness of Industry Portfolios

We investigate, from a portfolio performance perspective, the relative importance of country and industry factors as determinants of international equity returns in the Euro-zone over the 1990 to 2003 period. Although industry- and country-based portfolios are indistinguishable in terms of mean-variance efficiency and Sharpe ratios, we document remarkable changes in the structure of Euro-zone equity returns. Whereas country returns were more volatile but less correlated than industry returns in the early nineties, the opposite is true for the late 90s and the beginning of the 21st century. After the launch of the Euro, the fraction of Euro-wide industry risk unrelated to country factors nearly doubles. This striking increase in industry idiosyncratic risk suggests that cross-border diversification within a single Euro-zone industry fails to deliver the full benefits of international diversification. Indeed, it has caused a near doubling of the average annual gains from Euro-wide cross-industry diversification, from 5.2% p.a. in the convergence period to 9.7% in the Euro period. We argue that the increasing importance of industry factors may be related to the enhanced economic integration of Eurozone countries induced by the EMU convergence process.