Accounting for Geographic Exposure in Performance and Risk Reporting for Equity Portfolios

Accounting for Geographic Exposure in Performance and Risk Reporting for Equity Portfolios — March 2015

Executive Summary

Table 4: Return contribution to Developed market indices of stocks with varying Local Market exposure (bull market condition): The table below reports the breakdown of the annualised excess return of three developed market indices (S&P 500, STOXX Europe 600 and FTSE Developed Asia Pacific) into the performance of portfolios formed by sorting stocks based on their sales exposure to the local market (official region). We summarise performance attribution for bull markets, wherein a bull market is defined as calendar year quarters where the spread between local and foreign market returns is positive. The local and foreign equity benchmark for the US market are MSCI USA and MSCI AC World ex-USA; for Developed Europe are MSCI Europe and MSCI AC World ex Europe; and for Developed Asia Pacific are FTSE AW Developed Asia Pacific and FTSE Global ex Asia Pacific. To form portfolios, we sort stocks by their local markets sales exposures. We then select the top stocks up to 33% of cumulative market cap (High), and the bottom stocks up to 33% cumulative market cap (Low), and form cap-weighted high and low exposure portfolios based on these sorts. Stocks which are not included in either extreme portfolio form the medium portfolio (Mid). The portfolios are formed at the end of June every year, using geographic segmentation data for the previous fiscal year. The statistics are based on daily total return series (with dividends reinvested) in USD. The portfolio constituents are weighted by their total market capitalisation in (USD) at the end of June every year. For performance attribution, we use OLS regression, wherein the dependent variable is the excess return on S&P 500 and independent variables are the excess return on High, Mid and Low portfolios. All returns are in excess of the risk-free rate. The risk-free rate in US Dollars is measured using returns on the Secondary Market US Treasury Bills (3M). The source of geographic segmentation data is DataStream, supplemented by Bloomberg. High Low Bull market excess return Contribution % Contribution Contribution % Contribution S&P 500 10.72% 4.63% 43.17% 3.29% 30.68% STOXX Europe 600 31.69% 10.15% 32.04% 10.01% 31.57% FTSE Developed Asia Pacific 16.82% 7.53% 44.76% 4.40% 26.16%

exposure of stocks in terms of proportion of sales coming from emerging or local markets, it again underlines the usefulness of using geographic segmentation data in analysing the performance of equity portfolios. Conclusion In this paper, 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

that during bull markets, i.e. 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% compared to the contribution of low local market exposure stocks (4.40%). 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

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An EDHEC-Risk Institute Publication