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

Section 3: Application to Performance Attribution

exposure to emerging markets, wherein the number of stocks in both the top and the bottom portfolio is such that each portfolio's market capitalisation is 33% of the total market capitalisation of all the constituents in the respective indices. The middle portfolio has the stocks representing the remaining 34% market capitalisation of the index constituents. We then attribute the return of the index to the performance of the three portfolios. By construction, as the three portfolios represent equal market capitalisation of the index, any deviation from an equal contribution to the return of the index reflects outperformance (or underperformance) of a portfolio relative to other portfolios, each having different levels of exposure to emerging market sales. Similarly, we sort index constituents based on proportion of their sales coming from local markets. For example, we sort stocks in the S&P 500 by the proportion of their sales coming from the United States. Then we analyse the attribution of return of the indices to the three portfolios with different levels of sales exposure to their respective local markets. Note that the index and portfolio return we consider in the analysis are total return series, wherein dividends are reinvested in the index or the portfolios. The attribution of the index return into three portfolios is done using the Ordinary Least Square regression as explained below.

The previous section has documented that standard regional indices for developed markets carry considerable exposure to economies outside the declared region of the index due to the underlying structure of sales of index constituents. We now turn to a discussion of the effects that such exposure has on the performance of these indices. In particular, we distinguish between companies with varying degrees of underlying economic exposure (in terms of geographic sales breakdown), and attribute index performance to these different geographic exposure categories. First, we analyse the performance of developed market regional indices by attributing their performance to the performance of portfolios of stocks with different levels of sales exposure to emerging market countries, thus revealing for example how much the stocks with relatively high emerging market exposure have contributed to index performance. Second, we attribute index performance of portfolios of stocks with different levels of sales exposure to their respective home economy, allowing us to test whether performance is driven mainly by “local” exposure or “foreign” exposure. We use the following methodology for performance attribution. For each of the three indices (S&P 500, STOXX Europe 600, and FTSE Developed Asia Pacific), we sort stocks at the end of June every year by their sales exposure to emerging markets 10 . The sales exposure to emerging markets means the percentage of total sales of a company coming from emerging market countries, which is defined and calculated as in Section 2 of this paper. We then create three portfolios: in the top portfolio we select the stocks with highest sales exposure to emerging markets and in the bottom portfolio we select the stocks with lowest sales

10 - Note that at this stage only those index constituents are considered for which data was used to report geographic exposure of indices (Section 2).

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