Countries Versus Industries in Emerging Markets: A Normative Portfolio Approach

WINTER 2006 W hat should a portfolio manager in emerging markets (EMs) do? Should he first determine the optimal country weights (and then select the “best” stocks in each country), or first determine the optimal industry weights (and then select the “best” stocks in each industry)? That is the central question we address in this article. In order to do so, we depart from the previous literature by analyzing the issue from a normative point of view. In other words, our analysis does not focus on what portfolio managers or investors have done in the past in order to draw lessons for the future. Rather, it focuses on the choices investors should emphasize if they are skilful, or the choices they should avoid if they lack skill, regardless of their past behavior. Our main result is straightforward: Skillful portfolio managers and investors in EMs should focus on countries rather than on industries. We arrive at this conclusion using three different approaches—dispersion in returns, dispersion in utility, and option pricing—each of which we describe below. The rest of this article is organized as follows. The second section discusses the issue at stake, focusing on the discussion of country effects versus industry effects, as well as on the normative and positive approaches that can be used to answer the central question of this article. The third section describes our data and methodology. The fourth section reports and discusses the evidence. And final section summarizes our results and implications for portfolio managers and investors in EMs. An appendix with tables and pictures concludes the article.