Why Investing by Country Is the Wrong Way to Approach Equity Portfolios

Industry-based asset allocation strategies have yielded higher risk-adjusted results over the last 45 years, according to new research.

Illustration by II

Illustration by II

It’s smarter and safer for institutional investors to diversify their portfolios by industry, rather than implementing country-based strategies.

Industry-based asset allocation strategies offer better diversification and yield higher risk-adjusted results than country-based strategies, according to a study by Wolfgang Bessler of the University of Hamburg, Georgi Taushanov of Justus-Liebig-University Giessen, and Dominik Wolff of the Institute for Quantitative Capital Market Research at Deka Bank.

For their study, Bessler, Taushanov, and Wolff examined stock performance from 1975 to 2020. They constructed ten industry and ten country indices by allocating each stock to a country and an industry portfolio. In order to determine which technique was superior, researchers analyzed “time-varying effects,” such as recessionary and expansionary periods, which were based on the state of the economy. The researchers also included equity-only and equity-bond portfolios and portfolios with and without short positions, according to the paper.

While there was no dominating strategy for the entire period, researchers found that, on average, industry-oriented asset allocation strategies outperformed country-based asset allocations across different investment strategies and bond constraints. The researchers attributed industry-based strategies’ outperformance to common risk factors, such as quality and momentum.

“Interestingly, during periods of global economic shocks and crisis, industry allocations outperform country allocation as most countries suffer from similar downturns, but industry performance, in contrast, is quite diverse with some industries performing well (high-tech, pharma),” they said in the paper.

Globalization Works Out Better for Industry-Centric Portfolios

As a result of globalization and international supply chains, countries have become more integrated and correlated with one another than industries have, resulting in lower country and relatively higher industry diversification benefits. For example, the Covid-19 pandemic impacted all countries, but not all industries, Bessler said in a phone interview with Institutional Investor.

“Since Covid hit all the countries in the world, you don’t have ‘good’ and ‘bad’ countries,” Bessler said. But there have been “good” and “bad” industries: “Amazon, Google, Apple — all these internet giants — they moved up, because they benefited from everyone staying at home and being online.”

Inversely, during the global financial crisis in 2008, it was better to diversify by country, Bessler said, because the catastrophe was based in the U.S. real estate markets, and regions like Asia were not impacted.

“For most periods the industry-based portfolios achieve higher [results] than the country-based portfolios, except for the first ‘old economy’ period and for the period after ‘new economy’ bubble to and including the ‘global financial crisis’ period,” the paper said. “We observe that the relative advantages of industry- or country allocations are time varying.”

For asset owners, allocating along industry lines is stronger than along country lines, Bessler said, adding that an industry-based asset allocation strategy will be more beneficial over longer investment horizons.