Country picking

Country picking or country selection is a key decision for asset allocation and as such will define risk and return characteristics of a portfolio. Assets classes within a single country or economy exhibit strong correlation due to sharing underlying fundamental drivers such as interest rates, credit, equity and currency risk.

Investing in individual companies’ debt or equity is often more expensive than a broader country or economy specific index product such as a country ETF. High correlation to individual assets and lower costs of trading makes country ETFs an attractive investment vehicle. Indeed, country stylised ETFs have been taking a growing portion of institutional investors’ portfolios. In addition, research suggests that proven single name investment strategies such as value and momentum can in most cases be successfully executed using a country index.

Financial literature offers a growing number of equity country selection strategies for international investors. Most of these strategies are parallels of formerly discovered stock level cross-sectional effects and anomalies. Faber (2012) has found value effect among countries – contries with a small CAPE ratios outperform those with high ratio. Balvers and Wu (2006), Bhojraj and Swaminathan (2006), and Asness et al. (2013) have found evidence for country momentum and country reversal effect. Gwilym, Clare, Seaton, Thomas found that momentum works internationally and picking the right country index can add to the momentum performance. Macedo (1995), Kim (2012), and Zaremba (2015a) have argued that stock markets with low fundamentals relative to price outperform those with high fundamentals relative to price. Keppler and Traub (1993) and Keppler and Encinosa (2011) have concluded that when it comes to country equity selection, “small is beautiful”. Zaremba (2015b, 2015c) has examined a number of inter-market anomalies related to various quality and risk metrics. Finally, Harvey (2000) and Zaremba and Nowak (2015) have suggested, that the “skewness preference” phenomenon may be important for asset pricing not only at the stock level but also at the country level.

The number of country-level anomalies discovered constantly increases, but it is still relatively modest in comparison with the abundant literature on stock level effects. Only a few recent papers review dozens (Jacobs, 2015) or even hundreds (Harvey et al., 2015) of stock picking anomalies – making country investing a promising source of yet unexploited alpha returns.

In conclusion, country ETFs have been found to offer similar potential for cross sectional investment strategies compared to individual assets. This is due to high within economy correlation yet relatively low intra economy correlation. Research finds superior risk return ratio suggesting that country wide investment anomalies may offer greater capacity and robustness while having lower strategy transaction costs.

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