New research by EDHEC-Risk Institute questions the usefulness of analysing geographic equities exposures based on the stock’s place of listing, incorporation or headquarters. Head of applied research, Felix Goltz, suggests that in a globalised marketplace, a more meaningful analysis of geographic risk exposures, and performance attribution, comes from looking at geographic segmentation data including total sales disaggregated into sales from different geographies. This type of reporting allows investors to take account of the real geographic risks of their portfolios, whether in constructing strategic or tactical allocations.
In index construction and portfolio construction, stocks are typically assigned to a country or region based on their place of listing, incorporation or headquarters. But in the context of a globalised marketplace in which a company’s operations are usually not restricted to any single country or region, this practice is questionable, and its usefulness in risk reporting and performance attribution is limited.
In addition, now that accounting standards have made firm-level data on business activity across regions widely available, one might ask whether such data can be used for more meaningful geographic exposure reporting of equity portfolios.
To date, research on the use of geographic segmentation data has primarily focused on improving forecasts of a company’s earnings. In our research, supported by CACEIS as part of EDHEC-Risk Institute’s research chair on “New Frontiers in Risk Assessment and Performance Reporting” we analyse the usefulness of a company’s reported geographic segmentation data – or total sales disaggregated into sales from different geographies – in performance reporting and performance attribution.
Firstly, we analyse the application of geographic segmentation data in reporting the geographic exposure (proportion of sales coming from different geographies) of equity portfolios.
We report geographic exposure for five developed market indices (S&P 500, STOXX Europe 600, FTSE Developed Asia Pacific, FTSE 100 and STOXX Europe 50) for four regions (Africa & Middle East, Americas, Asia & Pacific and Europe) and for emerging and developed markets.
Secondly, we analyse the application of geographic segmentation data in performance attribution, where we attribute the yearly performance of the developed market index to the performance of portfolios which have varied levels of exposure to emerging markets or local markets (official market).
Here, we consider only three broad market indices (S&P 500, STOXX Europe 600 & FTSE Developed Asia Pacific) and not narrow indices such as the FTSE 100 and STOXX Europe 50, since sorting stocks based on varied levels of geographic exposure leads to portfolios with few stocks, which can lead to less meaningful results.
We also analyse performance attribution for indices in different market conditions, with performance attribution depending on: the difference in returns of emerging and developed market equity; and the difference in returns of local and foreign market equity.
Data and methodology
We report the geographic exposure of the index constituents at the end of June every year over 10 years (2004 to 2013). For the index constituents as of June t, we consider sales for fiscal year t-1 in order to avoid a look-ahead bias.
The source of geographic segmentation data is DataStream (Worldscope), supplemented by Bloomberg, which provides geographic breakdown of sales as reported by companies.
We report the geographic exposure of indices to four regions (Americas, Europe, Middle East & Africa and Asia & Pacific) as well as to developed and emerging markets.
To determine countries that constitute the above mentioned four regions, we rely on the United Nations Statistics Division (UNSD), which groups individual countries (economies) into sub-regions, further aggregated into geographic regions (continents).
UNSD does not have any standard methodology to classify countries into developed and emerging markets, so the classification of countries into developed or emerging is based on ERI Scientific Beta’s methodology. In effect, the countries in the United Nations’ list that are not categorised by ERI Scientific Beta have been grouped into the emerging market category.
Mapping reported geographic sales to individual countries
If a company reports sales per country, it is fairly simple to assign it to one of the four regions and to either the developed or emerging category.
However, companies can also report sales from sub-regions (such as North America and South America), regions (for example, the Americas), special economic or political groupings (like the European Union) or a mix of these (for example Brazil and North America).
In such cases, to achieve our objective, which is to report sales of index constituents from the four regions mentioned and from developed and emerging markets, we follow a two-step process.
First, we disaggregate sales for each reported geographic segment into country-level sales. The proportion of sales assigned to a country within a region is the same as the weight of the country’s gross domestic product (GDP) in the total GDP of the geography.
Second, we aggregate country-level sales back to sales from four regions and from developed and emerging markets. In what follows, we summarise the results of the application of segmentation data for reporting the geographic risk exposure and performance attribution of equity portfolios.
Application to performance and risk reporting
We examine the exposure of the developed market indices to four regions and to developed and emerging markets. The exposure is examined for the beginning (FY-2003) and end (FY-2012) of our 10-year sample period.
In terms of the regional exposure of developed market indices, all the indices have significant exposure to non-domestic regions in FY-2003. For example, the exposure of the S&P 500 to regions other than the Americas is 19 per cent. The exposure of the STOXX Europe 50 to non-domestic regions (regions other than Europe) is highest at 44 per cent.
Over a period of 10 years, the exposure of these indices to non-domestic regions has increased further. For example, the exposure of the S&P 500 to regions other than the Americas has increased by 8 per cent in a period of 10 years to 27 per cent in FY-2013.
To provide another perspective on the importance of the growing foreign market exposure of developed market indices, we find that for indices such as the S&P 500 and STOXX Europe 600, the sum of market capitalisations of the index constituents (or the cap-weight of the index constituents) weighted by percentage of sales from foreign markets was $2,852 billion (or 29.96 per cent in relative terms) and $2,469 billion (or 41.07 per cent), respectively, in June 2004, which rose to $5,638 billion (38.75 per cent) and $4,683 billion (53.28 per cent), respectively, in June 2013.
We therefore see a clear trend of foreign geographic exposure representing an increasing share of popular regional indices, while the extent to which companies focus clearly on the official region of the index in terms of geographic exposure has correspondingly decreased.
We also look at the emerging and developed market exposure of the five developed market indices. All the developed market indices had noticeable exposure to emerging markets in FY-2003, with the S&P 500 and STOXX Europe 600 having the lowest (6.97 per cent) and highest (10.67 per cent) exposures respectively.
Interestingly, the emerging market exposure of all the developed market indices has almost (or more than) doubled in the 10-year sample period. For example, the emerging market exposure of the STOXX Europe 600 has increased from 10.67 per cent in FY-2003 to 22.69 per cent in FY-2013.
We also find that for popular indices such as the S&P 500, FTSE 100 and STOXX Europe 50, the sum of market capitalisations of the index constituents (or the cap-weight of the index constituents) weighted by percentage of sales from emerging markets was $868 billion (or 9.12 per cent in relative terms), $202 billion (or 11.39 per cent) and $355 billion (12.48 per cent), respectively, in June 2004, which rose to $2,391 billion (16.44 per cent), $542 billion (24.63 per cent) and $1,070 billion (28.11 per cent), respectively, in June 2013.
These figures also highlight the rise in the emerging market exposure of developed market indices.
These figures tell us that the developed market indices have significant and increasing exposure to non-domestic regions and to emerging markets, which underlines the need to report the geographic risk exposure of equity portfolios in terms of geographic segmentation data and not just to rely on simplistic labelling of indices based on stocks’ places of listing or incorporation.
Application to performance attribution
We analyse the contribution of stocks with varied emerging and local markets exposure to the performance of developed market indices.
Here we focus on performance attribution conditioned on two different market conditions: performance attribution depending on the spread in returns of emerging and developed market equity and performance attribution depending on the spread in returns of local and emerging market equity.
To emphasise the core idea, we examine performance attribution during a bull market, or when the return on emerging market (or local market) equity is higher than the return on developed market (or foreign market) equity.
In terms of return contributions to developed market indices of stocks with varying emerging market exposure, we note that during bull markets, that is when the emerging market performed better than the developed market, the stocks with high exposure to the emerging market contributed more to the performance of the index compared to the contribution of stocks with low exposure to the emerging market.
For example, during bull markets, the contribution of high-emerging-market-exposure stocks to the performance of the STOXX Europe 600 is 7.83 per cent compared to the contribution of low-emerging-market-exposure stocks (5.47 per cent).
In terms of return contributions to developed market indices of stocks with varying local (official regions) and foreign market exposure, we note that during bull markets, or when local markets performed better than foreign markets, the stocks with high exposure to local markets contributed more to the performance of the index compared to the contribution of stocks with low exposure to local markets.
For example, during bull markets, the contribution of high local market exposure stocks to the performance of FTSE Developed Asia Pacific is 7.53 per cent compared to the contribution of low local market exposure stocks (4.40 per cent).
Overall, these figures suggest that when emerging markets fare better than developed market equity, the stocks with higher exposure to emerging markets contribute more to the performance of indices than stocks with lower exposure to emerging markets.
Likewise, we find that when local markets fare better than foreign market equity, the stocks with higher exposure to local markets contribute more to the performance of indices than stocks with lower exposure to local markets.
As we measure the exposure of stocks in terms of proportion of sales from emerging or local markets, this again underlines the usefulness of using geographic segmentation data in analysing the performance of equity portfolios.
In recent research, we analyse the usefulness of geographic segmentation data in reporting the geographic risk exposure and performance attribution of equity portfolios. We find that the indices that are labelled as representing developed market equity have significant and increasing exposure to emerging markets.
More globally, we observe that the economic exposure measured by sales in the domestic region that corresponds to the official definition of the index’s universe has been tending to fall sharply compared to exposure to non-domestic regions.
These economic exposures ultimately have an influence on variations in the performance of the index. As such, we find that the contribution to the performance of developed market indices of stocks with varied geographic exposure (either emerging market or local market exposure) differs noticeably.
These findings highlight the usefulness of geographic segmentation data in risk reporting and performance attribution of equity portfolios.
This reporting will also allow investors to take account of the real geographic risks of their portfolios, whether in constructing strategic or tactical allocations.
It would be a shame if asset allocators compromised their asset allocation policy, which is often based on macro-economic scenarios that use regional dimensions, through poor evaluation of the geographic reality of their portfolio or benchmark.