Country, Industry, and Risk Factor Loadings in Portfolio Management

Country effects declining in importance; industry effects growing.

Jean-Frangois L'Her, Oumar Sy, and Mohamed Yassine Tnani

JEAN-FRANCOIS L ' H E R is

a research advisor at Caisse de depot et placement du Quebec in Montreal (Quebec H3A 3C7).
jlher@cdp.ca

OUMAR S Y is an analyst at

Caisse de depot et placement du Quebec in Montreal (Quebec H3A 3C7).

o$y@cdp.ca
MOHAMED YASSINE TNANI

is an analyst at Caisse de depot et placement du Quebec in Montreal (Quebec H3A 3C7).

global portfolio built using a top-dovyn approach may usually be allocated on the basis of a country or industry dimension. T h e choice of dimension wiU depend on whether the portfoho manager beheves that returns are governed primarily by country or by industry effects. Heston and Rouwenhorst [1994, 1995], Griffin and Karoiyi [1998], and Rouwenhorst [1999] show that country effects, on average, dominated industry effects during the 1975-1998 period. Baca, Carbe, and Weiss [2000], Cavagha, Brightman, and Aked [2000], Kerneis and Williams [2000], and Hopkins and Miller [2001], however, point out that industry effects have grown so markedly in importance that they have superseded country effects in the variation of international stock returns. These trends in country and industry effects can be explained largely by ongoing capital market integration. The past few years have witnessed increased correlations between country returns (see Freimann [1998]). This phenomenon is attributable to a number of structural changes: reduction in international barriers to investment; major developments in information technologies that have improved access to global information; an unprecedented wave of global mergers and takeovers; a move toward privatization; and the integration of geographic zones, especially in Europe. Clobahzation ofthe world economy has hkely diminished the benefits of diversification across countries in favor of diversification across industries.

mtnani@cdp.ca
70

We use a two-step procedure to reexamine the relative importance of country and industry effects in the
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COUNTRY, INDUSTRY, AND RISK FACTOR LOADINGS IN PORTFOLIO MANAGEMENT

variation of international stock returns. The first step, which is estimation of the model, follows Heston and Rouwenhorst [1994, 1995] and Griffm and Karoiyi [1998].' In the second step, unhke previous authors, we separate the cross-sectional variance of monthly international stock returns into different effects, and then study the evolution of each component. Our work differs from other research in two key areas: the data set used, and, more important, the inclusion of global risk factor loadings in the analysis. Our data, taken fiom Standard & Poor's Compustat Global Vantage, cover 20 developed countries and 11 broad industries, and span the period July 1989 through December 2000. An advantage of our data set is that it covers a great number of stocks (7,348 firms), making it possible to obtain more cross-sectional variance in the size characteristics of firms. The more distinctive element of the research pertains to inclusion of global risk factor loadings in the model. Studies examining the relative importance of country and industry effects as a source of variation in international stock returns have assumed identical global risk exposure for each stock. Yet authors have demonstrated the presence of global premiums related to size (Heston, Rouwenhorst, and Wessels [1995]), book-tomarket (ArshanapaUi, Coggin, and Doukas [1998], Fama and French [1998]), and price momentum (Rouwenhorst [1998]) (see Liew and Vassalou [2000] for evidence on these three premiums). We use a global four-factor pricing model to control for differences in global risk factor loadings between international stocks. Using a country/industry dummy variable framework, we show that country effects dominated industry effects during the 1992-2000 sample period, corroborating the findings of Heston and Rouwenhorst [1994, 1995] and Griffm and Karoiyi [1998]. Consequently, country diversification was on average more eflicient than industry diversification during the nineties. Like Baca, Garbe, and Weiss [2000], Cavaglia, Brightman, and Aked [2000], Kerneis and WiUiams [2000], and Hopkins and MiUer [2001], we also note that industry effects have gained in importance. The ongoing trend toward integration has reduced the benefits of country diversification; consequently, industry-oriented approaches to global management could be as effective as country-oriented approaches in the future. Top-down approaches to global equity portfolio aUocation should consider both the country and indusSUMMER 2002

try dimensions. Carrieri, Errunza, and Sarkissian [2000, p. 26] conclude that: "In other words, ... investors should use both cross-country and cross-industry diversification as a way to improve portfoho performance" (emphasis in the original). More important, the globalization ofthe economy has also strengthened the role of global risk factors as a source of variation in international stock returns. While the main trends of the country/industry analysis remain the same, global risk effects became stronger during the sample period, and are currently more significant than country and industry effects. Consequently, global managers should consider exposure to these global risk factors when they construct their portfohos. DATA Our data set, extracted from the Standard & Poor's Compustat Global Vantage database, spans the period July 1989December 2000, and covers a total of 20 countries and 11 industries.^ The set covers 7,348 stocks, more than other studies, and includes smaU-capitahzation stocks, which enables us to obtain more cross-sectional variance in size factor loadings.' The sample includes aUfirmsfor which information as foUows is available: doUar-denominated total return, market capitaHzation, book-to-market ratio, and a description ofthe industry and country affihation." Exhibit 1 provides descriptive statistics on the returns observed from January 1992 through December 2000. Panel A gives the main return characteristics by country. On average, we examine 367 firms per country, but the number of firms and industries varies by country. The United States is by far the most represented, with almost one-quarter ofthe firms covered (1,757 firms) foUowed by Japan (1,682firms),and the United Kingdom (908 firms). With the exception of Finland, the most volatile index returns are observed in the Far East countries. Finland (4.04% per month) and Sweden (2.09% per month) are the countries with the highest cap-weighted average return. Austria and Japan recorded the poorest average returns (respectively, -0.12% and 0.16% per month). The low tracking error bet'ween the index returns of the G-7 countries and their corresponding MSCI country index returns is a guarantee of the quality of our data. Panel B provides the main return characteristics by industry. The number of firms in industries varies from 1,837 for consumer cychcals to 62 for communication serTHE JOURNAL OF PORTFOLIO MANAGEMENT 71

EXHIBIT 1 Country, Industry, and Global Retums January 1992-December 2000

Panel A. Countries Australia Austria Belgium Canada Denmark Finland France Germany Hong Kong Italy Japan Malaysia Netherlands Norway Singapore Spain Sweden Switzerland U,K, U,S, Number of Firms
241 61 64 363 81 52 382 370 144 152

1682 363
131 66 180 93 121 137

Mean Median
Panel B. Industries Basic Materials Capital Goods Communication Services Consumer Staples Consumer Cyclicals Energy Financials Health Care Technology Transportation Utilities Mean Median Panel C. Global Risk Factors

908 1757 367 148

Weight 1.41 0.17 0.67 2.23 0.34 0.57 4.28 5.33 1.85 2.25 18.82 0.69 1.96 0.24 0.51 0.96 0.85 1.97 8.75 46.13 5,00 1,63 Weight 6,02 8,91 9,93 9,86 12,30 4,24 19,50 6,82 15,75 2,53 4,14 9,09 8,91

Retum
0.80 -0.12 0.91 1.05 0.82 4.04 1.13 0.90 1.44 0.81 0.16 0.82 1.68 0.87 0,99 1,16 2,09 1,49 1.02 1,35 1,17 1,01

Standard Deviation 5,06 5.04 3,83 5,57 4,89 11,55 4,76 4,73 9,77 7,06 6,82 12,00 5,06 6,60 10,17 6,15 7,83 4,58 4,07 3,90 6,47 5,32 Standard Deviation 4,18 4,24 6,19 3,11 3,75 4,75 4,59 4,29 6,69 3,76 2,84
4,40 4,24

Number of Firms
712

Retum 0,56 0,89 0,86 0,84 0,57 1,15 1,17 1,29 1,92 0,33 0,81 0,94 0,86

1345
62 786

1837
206 909 290 722

288
191

668 712

t-test 2,80 1,69 0,74 -0,23 2,20

Retum 1,00 0,61 0,21 -0,08 0,76

Standard Deviation 3,72 3,72 2,93 3,60 3,58

WML..

Retums are expressed in USD. Weights, retums, and standard deviations are expressed in percentage on a monthly basis.

72

COUNTRY, INDUSTRY, AND RISK FACTOR LOADINGS IN PORTFOLIO MANAGEMENT

SUMMER 2002

vices. Over the period considered, technology (1,92% per month) and health care (1,29% per month) posted the best returns; basic materials (0,56% per month) and consumer cyclicals (0.57% per month) posted the lowest returns. The technology returns were the most volatile (6.69% standard deviation of monthly returns). At the other extreme, utilities returns registered a standard deviation of only 2.84%. Panel C shows the average return and standard deviation of each of the four global risk factors: the global market {R ), and three global zero net investment portfolios constructed on the basis of firm market capitalization (small minus big: SMB^), firm book-to-market (high minus low: HML^), and stock price momentum (winners minus losers: WML^). The global market posted a return of 1% per month (t-statistic 2,80), The global market premium was 0.61% per month and significantly differentfiromzero only at the 10% level. SMB^, HML^, and ^ML^ posted monthly returns of 0.21%,"'-0,08%,'and 0,76%, respectively. is significant at the 1% level (t-statistic 2.20), while and HML ^ are not significant.^ See the appendix for details on the construction of factors. METHODOLOGY The first methodology presented is based on country and industry fixed effects, and the second integrates country and industry fixed effects with global factor loadings. Country and Industry Fixed Effects We use a two-step procedure to differentiate between the variance of international stock returns due to country effects and the variance attributable to industry effects. The first step, which separates country-related performancefi-omindustry-related performance, is similar to the dummy variable regressionfi-ameworkused in Heston and Rouwenhorst [1994, 1995] and Griffin and Karoiyi [1998]:'^

wise, Ij is a dummy variable that equals 1 when firm j belongs to industry i (i = 1, ..,, 11) and 0 otherwise, and e.j is the error term. To solve the identification problem induced by dummy variables and to facilitate interpretation of the coefficients, we impose the same restrictions as Heston and Rouwenhorst [1994,1995] and Griffin and Karoiyi [1998]:
20

(2-A)
c=l II

(2-B)

where (f)^^ ^ and (p.^ ^ are the weights of country c and industry i in the world portfolio at the beginning of the month. Given these restrictions, the parameter a^^ can be interpreted as the cap-weighted average return of the world portfolio at time t, and coefficients /^^ and X.^ stand for the "pure" bet at time t on country c without industry bias and the "pure" bet on industry i at time t without country bias. In the second step, the cross-sectional variance of the international stock returns is segmented in order to identify the proportion of the variance attributable to stockspecific {S/T ), country {C/T ), and industry (I/T ) effects. This allows us to determine for each month components that best explain the cross-sectional variance of international stock returns. The three components are calculated as follows:

C.

c=l

t_

T. ~

(3)

where, T^ = S^
(1)

stands for the total effects.''

Fixed Effects and Global Risk Loadings

where R., is the return of firm j (;' = 1, .,., N = 7,348) for period (, C^. is a dummy variable that equals 1 when firmj belongs to country c (c = 1, ,.., 20) and 0 otherSUMMER. 2002

The analysis considers fixed country and industry effects exclusively, and assumes that all stocks have the same global risk exposure. Our main contribution is to examTHEJOURNAL OF PORTFOLIO MANAGEMENT 73

ine the relative importance of loadings on the four global risk factors and country/industry dummy variables as a source of variation in international stock returns. We use a four-factor global pricing model to estimate the factor loadings for each stock j()3_.,, y3,,.,, ^,,.,, andi^^.,) and then estimate this model monthly:*

EXHIBIT 2 Evolution of Stock-Specific, Country, and Industry Effects Year

1992 1993 1994 1995 1996 1997 1998 1999

Stock-Specific
67,65 68,11 72,51 75,80 78,94 73,32 77,30 75,35 74,76 73.75 74.76

Country
26,81 25,35 21,26 17,99 14,70 19,02 13,72 9,75 7,85 17.38 17.99

Industry
5,54 6,54 6,23 6,22 6,36 7,67 8,98 14,90 17,39 8.87 6.54

20

c=l

(4)

2(X)0 Mean Median

where C(^ is the world return for the period t that is not explained by the four global risk factors, and the parame^^^^ ^umt' u.' "whr an'^ ,^, represent the global risk premiums associated with each factor loading. Equation (4) makes it possible to compare country and industry effects while controlling for differences in exposure of international stock returns to the four global sources of risk. Restrictions (2-A) and (2-B) are also imposed in Equation (4). As in the country/industry analysis, the second step consists of subdividing the cross-sectional variance of international stock returns into four components: the stock-specific (S/T), country (C/T), industry (I/T), and global risk factor loading (G/T) components. The first three components are calculated using the procedure above (except T), while the fourth, which is the variance explained by global risk factor loadings, is equal to:

Each effect is measured by the average annual proportion ofthe variance that is due to the stock-specific, country, and industry components [Equation (3)]. Proportions expressed in percentages.

we analyze the results obtained when global factor loadings are introduced. We then investigate the robustness of the results using a different industry classification, fewer countries, and only large market capitalization firms. Country and Industry Fixed Effects Exhibit 2 shows the contribution of each of the three effects (specific, country, and industry) to the crosssectional variance of international stock returns for each year studied. With on average 73,75% ofthe total effects, the stock-specific component largely dominates the other effects. This result confirms the relevance of investing in a portfolio rather than in a single stock, given that the stock-specific component can be significantly reduced by forming a portfolio of non-perfectly correlated securities. The remainder of the international stock return cross-sectional variance is explained by country and industry effects. For the total sample period, country effects explain on average 17,38% ofthe return variance, dominating the 8.87% explained by industry effects. This result is consistent with the conclusions of Heston and Rouwenhorst [1994, 1995] and Griffin and Karolyi [1998]. There are significant portfolio management implications to be drawn from the dominance of country effects over industry effects in the variation of international stock returns. The most important is that diversification across countries has been more effective than diversification across industries during this period. As Heston and
SUMMER 2002

(5)

where T^-Sj + Cj + I^ + G, represents the total effects. To assess the relative importance of each individual global factor loading, we separate the {G/T^ variable into four components related to the exposure to global market {RJT), size (SMBJT), book-to-market (HMLJT), and return momentum {WML /T).' RESULTS We present the results ofthe methodology that considers solelyfixedcountry and industry effects first. Next,
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COUNTRY, INDUSTRY, AND RISK FACTOR LOADINGS IN PORTFOLIO MANAGEMENT

Rouwenhorst conclude: "There are substantial benefits to international diversification beyond the amounts attributable to industrial or currency diversification" [1994, p. 26]. This result nevertheless overshadows the evolution of country and industry effects. There has been a significant shift from country to industry infiuences in recent years. Indeed, the relative importance of country effects declined significantly during the period studied, dropping from 26.81% of the total effects in 1992 to 7.85% in 2000. This decline is consistent, except for 1997. Conversely, the relative importance of industry effects has continued to increase. The portion ofthe global return variance accounted for by industries increased from 5.54% in 1992 to 17.39% in 2000. As a result, industry effects exceeded country effects as a source of variation in crosssectional returns for 1999 and 2000. During these two years, diversification across industries would have been more advantageous than diversification across countries. This result is consistent with results in Baca, Garbe, and Weiss [2000], Cavaglia, Brightman, and Aked [2000], and Hopkins and Miller [2001]. Hopkins and Miller emphasize that the increase in industry effects is indicative either of more extreme sector returns around the global average or of the rising importance of sectors as drivers (information technology, energy, and utilities). Fixed Effects and Global Factor Loadings Exhibit 3, Panel A, presents the results of estimation of Equation (4), which combines bothfixedcountry/industry effects and global risk factor loadings. The informaEXHIBIT 3

tion included in this panel somewhat resembles that of Exhibit 2, except that it introduces the differences in global risk exposure as a source of variation in international stock returns. The stock-specific component remains very high at 72.75% on average (a slight decline from a level of 73.75% with fixed effects only). For the entire sample period, country effects on average continue to dominate industry effects (14.77% versus 7.64%). While the fixed effects model assumes that all stocks have the same global risk exposure, results here show that global factor loadings explain on average 4.83% ofthe return variance. As in the analysis based solely on country and industry fixed effects, the relative importance of country effects in the variation of international stock returns has drasticaUy dechned (from 22.07% in 1992 to 8.20% in 2000). Industry effects have gained concomitantly in importance; they represented 4.62% ofthe cross-sectional variance in 1992 versus 10.71% in 2000. Since 1999, industry effects have even surpassed country effects. The most interesting result pertains to global factor loadings. From 1992 to 2000, the global factor loadings as a source of variation in international stock returns have grown so dramaticallyincreasing fiom 6.20% in 1992 to 11.51% in 2000that global factor loadings outweighed country and industry effects in 2000. As the global factor loading effects are non-diversifiable, we can conclude that benefits of international diversification have been significantly declining in more recent years, particularly in 2000. Exhibit 3, Panel B, shows the breakdown of the global factor loadings into four components. The correlations between the four global risk factor loadings aside.

Evolution of Stock-Specific, Country, Industry, and Global Risk Effects

Panel A Stock-Specific Country Industry 4.62 67.11 22.07 21.84 6.46 67.19 5.85 71.92 19.15 5.73 15.69 75.11 13.51 6.09 78.23 16.64 7.15 72.00 7.24 75.51 13.49 9.68 11.90 72.47 10.71 8.20 69.59 14.77 7.64 72.75 6.80 14.60 72.23 Panel B B-to-Mkt 2.62 1.07 0.45 0.44 0.25 0.69 1.23 1.64 2.72 1.06 0.88

Year 1992 1993 1994 1995 1996 1997 1998 1999 2000 Mean Median

Global 6.20 4.52 3.07 3.47 2.17 4.21 3.76 5.96 11.51 4.83 3.99

Market 0.77 0.43 1.32 0.89 0.71 0.53 1.51 3.70 2.60 1.46 1.11

Size 0.96 1.27 0.95 1.19 0.57 1.68 0.36 0.35 2.61 1.12 1.07

Momentum 2.41 1.56 0.38 0.59 0.59 2.10 0.78 0.39 1.31 0.96 0.69

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THE JOURNAL OF PORTFOLIO MANAGEMENT

75

the most important global risk exposure is that of the global market, with 1.46% ofthe total variance followed by SMB, HML, and WMLvnth 1.12%, 1.06%, and 0,96% of the variance, respectively. The increase of the relative importance of global factor loadings as a source of variation in international stock returns is driven mainly by the increase in the percentage of variance explained by the global market and size loadings (from 0.77% and 0,96% in 1992 to 2.60% and 2.61% in 2000). The percentage explained by the book-to-market loadings increased by only 0.1% for the same period, while that explained by the momentum loadings declined from 2.41% in 1992 to 1.31% in 2000. ROBUSTNESS OF RESULTS We also analyze the sensitivity of the results to the definition of industries, the number of countries studied, and firm size. First, we analyze whether the tests could be biased against finding any industry effects. Following GrifFm and Karolyi [1998], we use a more refined classification of industry sectors, to include 21 subindustries rather than 11 industries. We also examine the results for a possible bias toward finding country effects by considering only the four largest stock markets: United States, Japan, United Kingdom, and Germany (77% of the global market capitahzation for 1992-2000). In addition, we look at how the country, industry, and global factor loadings effects behave when managers are restricted to the largest global stocks. Exhibit 4, Panel A, shows the results for a classification based on 21 subindustries. Such a classification slightly amphfies the industry effects for all the years considered. Compared with Exhibit 3, the average industry effect rises from 7.64% to 8.52%. This modest increase in industry effects is accompanied by a slight increase in country effects (14,77% to 15,59%), mostly to the detriment of stock-specific effects, which decline on average from 72,75% ofthe total effect to 70,95%. Consequently, we conclude that the industry classification has little impact on average results, consistent with Griffin and Karolyi s [1998] finding. The declining weight of the country effects persists with the more refined industry classification, while the upward trend of global and industry effects remains the same. Exhibit 4, Panel B, shows the results when the global portfolio manager is limited to the U.S., Japan, the U.K., and Germany. Compared with Exhibit 3, the average country effects dechne from 14.77% to 10.97%. This
76

EXHIBIT 4

Evolution of Stock-Specific, Country, Industry, and Global Risk EffectsSensitivity Analysis

1 Year | Stock-Specific Country Industry Global Panel A. 20 Countries and 21 Subindustries 1992 66.00 22.12 5,71 6,18 1993 65.77 21,89 7,86 4.48 1994 71.19 18.74 6.98 3.08 1995 73,92 15.61 6.96 3.51 1996 76.75 13.84 7.35 2,07 1997 70.71 16,72 8,50 4,07 1998 74,69 13,30 8,40 3,61 1999 71,47 9,84 12,74 5.96 2000 68,08 8,27 12,18 11,47 Mean 70.95 15.59 8.52 4.94 Median 71.19 15.61 7.86 4.07 1 Panel B. Four Largest Stock Markets 1992 68.50 16.94 5,61 8,96 1993 70,11 15.09 8.38 6.43 1994 75,92 12.11 7.64 4.34 1995 74,88 13.17 7.42 4.53 1996 78.64 10,88 7,69 2,80 1997 74,16 11,44 8,77 5.63 1998 78,45 8,11 8,83 4.61 1999 74.25 5.96 12.98 6.81 2000 70.78 5.02 11,76 n.u Mean 73.96 10.97 8.79 6.28 Median 74.25 11.44 8.38 5.63 Panel C. 25% Largest Companies in the World 1992 60,95 24.40 5,92 8.73 1993 60,65 23.85 8,69 6.81 1994 66.71 21,25 7.68 4,36 1995 69.58 16,62 7.24 6,57 1996 73,70 7.87 15,54 2,88 1997 69.59 16.76 8.93 4.73 1998 73,65 13.83 8,32 4.20 1999 69.82 10.23 13.18 6,77 2000 67.49 8,65 11.60 12.26 Mean 68.02 16.79 8.83 6.37 Median 69.58 16.62 8.32 6.57

drop translates into an increase in the relative importance of industry and global risk effects. Industry effects are clearly stronger when we consider only the four largest markets (8.79% versus 7.64%). Moreover, industry effects dominate country effects as early as 1998, The average global risk effects, meanwhile, increase from 4.83% to 6,28%. The reduced benefits of international diversification are thus more marked if we consider the four largest stock markets exclusively.
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COUNTRY, INDUSTRY, AND RISK FACTOR LOADINGS IN PORTFOLIO MANAGEMENT

Panel C shows the stock-specific, country, industry, and global risk effects when only the top 25% of firms in terms of market capitalization are considered, Kerneis and Williams [2000] have shown that the large-cap stocks have a more sensitivity to global industry factors than the total universe. Our earlier results are not materially changed by restricting the total universe to large-cap stocks. Like Kerneis and Williams [2000], we note that the stock-specific components have less impact in the largecap universe. This decline ofthe stock-specific component results in heightened industry effects (from 7,64% to 8,83%), country effects (from 14.77% to 16.79%), and global risk effects (from 4,83% to 6.37%). Even for largecap companies, country effects have on average dominated industry effects during the period of 1992-2000, Industry and global risk effects, however, are still more apparent than country effects in 1999 and 2000. SUMMARY

role of global risk factors in explaining co-movements in international stock returns. The extent of stock market returns explained by differences in exposure to global risk factors rose considerably during the period covered. Global risk effects dominated both country and industry effects in 2000, with 11,51% versus 10,71% for industry effects and 8.20% for country effects. Global management strategists could consequently delineate asset classes on the basis of their global risk factor loadings. The trend toward globalization is instrumental in determining the relative importance of country, industry, and global risk effects. The structural changes in global economies probably explain why in the last decade country effects have been losing ground in favor of industry and global risk effects. Given that these three effects have become equally important in the recent period, it is best to consider all three dimensionscountry, industry, and global risk factorsin constructing portfohos. APPENDIX

We have compared the relative importance of country, industry, and global factor loading effects in explaining the variation in international stock returns during the 1990s (from January 1992 through December 2000), We factor a risk dimension into the analysis, making it possible to identify the portion ofthe variation in international returns attributable to global risk levels incurred. If we consider the country and industry dimensions exclusively, on average country effects dominated industry effects over the entire period. Consequently, diversification across countries was on average more efficient than diversification across industries. Country effects dechned significantly during the nineties, however. The portion of the return variance attributable to country effects declined from 26.81% in 1992 to only 7.85% in 2000, a decrease of 70.72%. Industry effects came to play a greater role in explaining the variance of international stock market returns, shifting from 5.54% in 1992 to 17,39% in 2000; they dominated country effects in both 1999 and 2000. Thus, ongoing global integration has made industry-oriented approaches to global investment as effective as country-oriented approaches. By implication, global management strategies should pay greater attention to the benefits of industrial diversification. As country effects remain more than trivial, however, asset classes should be defined using both country and industry dimensions to maximize the benefits of diversification. Furthermore, globalization has strengthened the
SUMMER 2002

Construction of Global Risk Factors

As we focus on both country and industry effects, we do not compute global factors as weighted averages of country (see Fama and French [1998]) or industry factors. Instead, we compute them regardless of countries or industries. For each month t from July of year y - 1 to June of year y, we rank stocks based on size and book-to-market ratio ofjune y - 1 and their previous performance between t - 12 and t 1, We perform independent sorts beginning in July 1990 to create SMB^^, HML^, and WML^. We use 50% break points for size, and 30% and 70% break points for book-to-market and prior performance. Following Fama and French [1993], we form six global value-weight portfoHos, S/L, S/M, S/H, B/L, B/M, and B/H, as the intersection of size and book-to-market groups. We follow the same procedure for prior performance as for book-tomarket; that is we form six global value-weight portfolios,

S/L, S/M, S/W, B/L, B/M, and B/W, as the intersection of size and prior performance groups, SMB^, HML^, and WML^ are as foUows: SMB^, = {{S/L- B/L) + {S/M- B/M) + {S/H - B/H)]/3, HMLJ= [{S/H-S/L) + (B/H- B/L)]/2, and WML^ = [{S/W-S/L) + {B/W- B/L)]/2.
Consequently, our methodology can be compared directly to neither that of Liew and Vassalou [2000], who use three sequential sorts, nor to that of Arshanapalli, Coggin, and Doukas [1998], who use 70% and 30% break points for SMB and construct HML by selecting the highest book-to-price stocks until half of the capitalization of each market is accumulated.

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ENDNOTES
The authors thank for insightful comments Stephanie Desrosiers, Richard Guay, Walid Hached, and Aurel Wisse, and for helpful translation assistance Karen Sherman. 'This dummy variable regression framework was first developed by Solnik and de Freitas [1988] and Grinold, Rudd, and Stefek [1989]. It was later used by Beckers et al. [1992], Drummen and Zimmerman [1992], Roll [1992], and Heston and Rouwenhorst [1994], among others. ^The countries are Canada, the United States, Malaysia, and 17 ofthe 20 countries in the EAFE index. Like Cavaglia, Brightman, and Aked [2000], we focus only on developed countries that are more economically integrated in order to avoid a possible country bias effect related to emerging countries. The Compustat database defines 12 industries. There are few firms and only four countries in the biotechnology sector, so we group it with the information technology sector, resulting in 11 industries. To analyze the sensitivity of results to the definition of industries, we use the first two digits ofthe Compustat 103-sector additional classification, leading to a classification of 21 subindustries. ^On the whole, 14,452 securities were extracted from the database. We dropped 3,534 securities that are not classified within an industry, and then subsequently eliminated 3,570 firms lacking sufficient data. This process resulted in a sample of 7,348 firms, of which 1.21% are inactive. Heston and Rouwenhorst [1994] use 829 firms; Griffin and Karoiyi [1998] about 2,600. More recently, Baca, Garbe, and Weiss [2000] and Cavaglia, Brightman, and Aked [2000] examine 3,212 and 2,645 firms, respectively. ''With respect to dollar retums, Heston and Rouwenhorst emphasize that "most of the variance of the country effect cannot be explained by currency movements" [1994, p. 24]. ^By comparison, Liew and Vassalou [2000] report in ten major markets over 1978-1996 both economically and statistically significant premiums. Furthermore, because growth stocks posted a relatively high return in the 1992-2000 period, the HMLu; premium is much lower than the ones reported by Fama and French [1998] and ArshanapaUi, Coggin, and Doukas [1998] over the 1975-1995 period. 'As in Griffin and Karoiyi [1998], in order to take into consideration the relative impact of market capitalization, we use the weighted least squares method rather than the ordinary least squares method. 'To calculate the cross-sectional variance, each stock is assigned a weight equal to its capitalization weight in the world portfolio at the beginning ofthe month. Note that the decomposition ignores the covariance between the fixed industry and country effects. The proportion ofthe variance attributable to specific effects is therefore not perfectly equal to 1 - R l This approximation is reasonable insofar as covariance between fixed industry and country effects is not very different from zero.
78

loadings on the global market and the three zeronet investment portfolios are estimated after June 1993 using 36-month moving windows (between t - 37 and t - 1) and imposing the restriction that 24 months of data be available in each security window. For the first months, however, we use shorter moving windows. For better comparison, we estimate both model specifications from 1992 through 2000. 'These components are calculated using the equations Var\

, 3.ncl

The sum of these individual components is not equal to the global factor loadings effect, G/T^ because this latter term considers the covariances between these components.

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