The EMU and changes in optimal diversification strategies in Europe: The importance of industry vs. country effects

Current Version: February 2004 ______________________________________________________________________ Abstract Have the introduction of the euro and the realization of the European Economic and Monetary Union (EMU) changed correlation structures between European countries and industries? The answer to this question has major implications for funds managers across Europe. Although the investment community agrees on the benefits of international diversification, there is an ongoing discussion whether diversification should be based on countries or on industries. The basic issue underlying this debate concerns the relative importance of country and industry factors in stock returns. This paper presents an empirical study to accurately estimate country and industry effects in the EMU-area and evaluates the consequences for international diversification benefits. Extensive empirical data is analyzed to derive reliable results. We find that with the integration in Europe the importance of country effects has dropped significantly, while industry effects grew more important. After decades where country effects were dominating, industry effects are more effective today in eliminating risk. This is reshaping portfolio selection in Europe, as diversification across industries has become more important than diversification across countries.