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

Introduction

analyse the application of a company's reported geographic segmentation of sales for two purposes: reporting the geographic exposure (proportion of sales coming from different geographies) of equity portfolios and analysing the performance of equity portfolios in terms of contribution from stocks with varied levels of exposure to different geographies. A substantial number of papers in accounting research have analysed the application of geographic segmentation data, focusing primarily on its usefulness in improving forecasts of a company's earnings. Roberts (1989) notes that for UK companies an earnings forecast model which uses geographic segment data outperforms a model based on consolidated data. Balakrishnan et al. (1990) report that geographic segmentation data gives additional information about earnings, leading to better forecast of sales and earnings of companies. Similarly, Ahadiat (1993) notes that although consolidated data is useful in predicting earnings, the geographic segmentation improves the accuracy of the prediction model. Li et al. (2014) extends the research to larger dataset than used by previous authors and also in another direction. The authors provide evidence that combining information on firm-level exposure to different countries and information about performance of the individual countries improves the forecast of company's fundamentals. Moreover, it documents that security prices are slow in incorporating information about geographic segmentation data, and a trading strategy constructed to exploit it has statistically significant performance that remains unexplained by standard

Performance and risk reports of equity portfolios frequently report a breakdown of portfolio holdings by geography, based on simple markers such as the stock’s primary listing and the firm’s place of incorporation and headquarters. However, it is questionable whether these markers are relevant for the underlying geographic exposure of a stock. For example, should an automaker who is listed, headquartered and incorporated in Germany, and sells his cars mainly to the US and China be considered as providing exposure to Germany, or even to Europe? Should stock of a Swiss-listed and headquartered pharmaceutical company which sells its products worldwide be considered to provide exposure to “Switzerland” or even to Europe? Beyond such examples, in a world of increasing globalisation, it is clear that the typical markers used for labelling firms as belonging to a certain country lose their relevance. In fact, even the practice of assigning a unique nationality for each stock seems obsolete in a world with multinational corporations. This question has numerous implications, whether involving performance attribution or geographical risk measurement for portfolios, and of course for investors’ and managers’ strategic or tactical allocation choices. At the same time, changes in accounting standards have made firm-level data on business activity across geographic segments much more widely available over the recent decade. Given the rich information available on the breakdown of sales in particular, a natural question is whether such data can be used to obtain more meaningful geographic exposure reporting of equity portfolios. This paper analyses the application of a company's reported geographic segmentation data in portfolio construction. In particular, we

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An EDHEC-Risk Institute Publication