Equity Valuation and Portfolio Management

KEY POINTS

• The academic literature has focused on the explanatory power of country membership with respect to the cross-section of individual stock returns. The literature has devoted less attention to the impact in an active portfolio management context.
• Understanding unintended bets that can arise when ignoring country membership in stock portfolio construction is important for active investors.
• In any active management strategy, accurate risk allocation is crucial. In particular, not allocating risk to unintended bets is first order. We demonstrate that avoiding unintended country exposures in stock portfolios requires careful portfolio construction.
• These issues arise in any global stock investment context, but are especially challenging in emerging markets. In emerging markets, lack of country neutralization can yield stock selection portfolios as little as one-third attributable to stock-specific bets and as much as two-thirds driven by country exposures. In developed markets, that decomposition can be as off-target as half stock bets and half country bets.
• Importantly, in both regions, a significant portion of the resulting country exposures may represent “noise” (i.e., bets that bear no relation to the underlying investment idea and that are thus a zero-alpha, pure opportunity cost).
• By properly adjusting stock selection portfolios for country membership, a manager can achieve accurate risk allocation and can prevent “noise pollution” of alpha signals. As a practical matter, ...