In previous posts, we looked at a number of explanatory “factors” which may explain the returns on stocks.

But there’s one variable we didn’t discuss.

For some reason, in the factor literature, the country of a stock is rarely considered to be a “factor.” But in practice, most investors do consider country to be relevant. Country (or region) is often considered to determine asset class.

Factors

The majority of stock factor research has been conducted on US stocks.

As we discussed in previous posts, of the hundreds of factors that have been proposed and studied, few seem to be robust to both replication (i.e. they are there when studied by others or in other data sets) and persistence (i.e. the factor continues to work after it is made public).

These more robust factors have been studied in international markets. In a 2021 paper[1] Klaus Grobys and James Kolari report weak support for most of the six factors – market return, value, momentum, profitability and “investment”. They report “size does not matter in any of the international equity markets.”

Data Limitations

Most of the research on factors in international markets is limited by the availability of data to a significantly shorter period than is the US research. As many researchers acknowledge, even in the US, and even assuming that the underlying processes (which are unknown and unobservable) that produce the factors are constant, we don’t have nearly enough data to be highly confident that we are measuring something that is real and persistent, rather than something that has arisen by chance, or has arisen as a result of idiosyncratic conditions that are unlikely to persist in future period.

Why Look at Regions or Countries?

Most countries, particularly in the developed world of North America (the US and Canada are an important exception), Europe and Asia, are defined at least partially by one or more of language groups, ethnic groups, cultural homogeneity and/or religious homogeneity, and in the post-gold-standard era, currency.

For example, Japan is distinct from the rest of Asia in terms of ethnicity, race, religion and language. Similarly, the UK, another island nation, has a long history of being distinguished from Europe by language, and for the last five hundred years by religion and culture. Most of the countries in Europe have their own language, and exist as countries largely because of regional differences in language and culture.

Currency Blocs

Most economists believe that money plays an important role in economic activity.[2] And in an era in which money is controlled by central governments, and each issuing government exerts significant influence over the currency it issues, and thereby over the economy which uses that currency, it makes sense to consider whether regions defined by currency should be treated as different markets.

For this reason, it is commonplace for investment regions to be defined by the currency bloc to which they belong. Thus, for example, Canada and the United States, which to a very large degree share a common history, a common language, common culture, common religion, and have highly integrated economies, but do not share a currency, are considered different markets by most people.

Since 1985, the correlation of returns between Toronto and New York has been a bit less than 80%. Here is a plot of the monthly returns on the Toronto Index against the S&P 500.

Everything else equal, a US investor would have obtained diversification by including Canadian stocks in addition to the S&P 500.

Regions or Countries?

The Eurozone is the only large group of developed countries that share a currency. Does this sharing of a currency mean that the stock markets are also closely linked? The evidence is mixed. The European Central Bank published an extensive study in 2008[3] that looks at many aspects of the question. The evidence seems to suggest that the country of a company explained more of the variance than did the industry.

The study, and others, also find that being a member of the Eurozone, other things equal, tends to increase the co-movement of stock markets.

European Countries or Eurozone Bloc?

For non-European investors, there is probably little practical difference between selecting individual European country markets for diversification purposes, and selecting the entire Eurozone.

Rest of the World

At recent count, there are at least 44 different countries with at least one ETF devoted to investing in the stocks of that country. There are also dozens or hundreds of funds that group countries on the basis of region, such as Asia, Asia ex-Japan, Asia ex-China, Latin America, etc.

Expenses and Weighting

The range of expenses on funds investing in non-US equities is very wide. For example, a recent review shows that the iShares Core MSCI Total International Stock ETF has an expense ratio of 0.07% (7 basis points). Other funds have expense ratios exceeding 1.2%.

Most of the lower expense ratio funds invest according to an index, such as the MSCI total international stock index. And most of these indexes are market cap weighted. That means, for example, that the index has about 15% of its exposure in Japan, 10% in the UK, all the way down to 0.01% in the Faroe Islands.

How Many Country Stock Asset Classes?

There is not enough historical evidence to determine the “correct” way to define equity assets classes by country. Does Japan constitute its own asset class? Very likely yes. Does the UK? Again, probably yes.

But within the Eurozone? Probably not. Here is a chart of the German and French stock market indexes since 1991. Those are by far the two biggest markets in the Eurozone.

It seems likely that for US investors, the great majority of the benefit of international diversification can be obtained by owning non-US stocks, and it probably makes much less difference whether those are determined by region or by specific country.

Factors in Non-US Markets

The evidence regarding factors suggests that factors have behaved similarly in international markets as they have in the US markets. Here, for example, is a graph produced by Fidelity.[4]

The evidence thus suggests that the same factors that might be considered for the US market also apply in non-US markets.

Which Countries are Asset Classes?

There is no hard and fast rule for determining whether to consider a country’s equity market as an asset class. However, a number of smaller countries that might be listed, and even have an ETF dedicated to that market, are dominated by one or two companies.

The following table shows examples of some markets that are dominated, to a greater or lesser extent, by a single company.

The potential concentration in a single company, such as Novo Nordisk comprising 50% of the Danish market, should be taken into account when considering a country as an asset class. Denmark, as the example shows, on a capitalization weighted basis, is really mostly Novo, as Taiwan is dominated by Taiwan Semiconductor.

Countries and Regions

The size and diversification of the market is no guarantee either. For example, as was illustrated above, the markets of France and Germany are so highly correlated with each other that virtually no diversification benefit is obtained by adding France if Germany is already owned, or Germany if France is already owned.

Thus, most people will probably look at some markets at the country level, and others at a regional level.

Good arguments can be made that the following countries and regions represent different asset classes:

Country Asset Classes

1. US
2. Canada
3. UK
4. Japan
5. China
6. Europe (Eurozone)
7. Asia ex-Japan, China and India
8. India
9. Latin America
10. Emerging Markets

Latin America is dominated by the Brazilian market. Even so, significant diversification can be gained by including other Latin American markets, as shown in the following table of market correlations:[5]

For most investors, it will probably make sense to consider some of the larger country stock markets, such as those listed above as Country Asset Classes, as equity asset classes, and to consider most other country markets as part of a group instead of by individual countries.

We’ll talk about that next time. Stay tuned!

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[1] Choosing Factors: The International Evidence, Grobys and Kolari, Applied Economics, Vol 54

[2] An interesting fact that is probably less widely known than it should be is that the holy grail of macro-economics – the so-called model of General Equilibrium – is based on an economy without money. In General Equilibrium, there is no need for money.

[3] https://www.ecb.europa.eu/pub/pdf/scpwps/ecbwp931.pdf

[4] https://www.etf.com/docs/Translating%20Factors%20to%20International%20Markets.pdf

[5] This correlation data is from an old study, and may not hold for other periods. Note, also, that some markets may not be investable by Americans. For example, as of this writing, PDVSA represented over half of the market cap of the Venezuela market, but Americans, under the sanctions regime in place, are not permitted to own it. https://www.e-jei.org/upload/6MKHT65YG1022JJ0.pdf.