Is Geography the Next Smart Beta?

Research suggests understanding the geographical sources of index returns is more important than ever.

The geographical reach of listed companies is a more important driver of index returns than ever before, according to research by the EDHEC-Risk Institute.

The findings were published in a paper titled “Accounting for Geographic Exposure in Performance and Risk Reporting for Equity Portfolios”, written by Noël Amenc, Felix Goltz, and Jan-Philip Schade from EDHEC-Risk, and Nicolas Gonzalez and Kumar Gautam from ERI Scientific Beta.

The overseas exposure of the S&P 500, STOXX Europe 600, and FTSE Developed Asia Pacific indices were analysed by the authors to ascertain what type of companies drove performance in different periods.

“It would be a shame if asset allocators compromised their asset allocation policy through poor evaluation of the geographic reality of their portfolio.” —EDHEC-RiskBetween 2003 and 2013, the report found that the S&P 500’s exposure to regions outside the Americas grew from 19% to 27%. For the STOXX Europe 600, exposure to non-European regions grew from 36% to 45%.

“These economic exposures ultimately have an influence on variations in the performance of the index,” the authors wrote. “As such, we find that the contribution to the performance of developed market indices of stocks with varied geographic exposure (either emerging market or local market exposure) differs noticeably.”

The researchers said that by providing more information about the actual geographical exposures of index constituents, it would “allow investors to take account of the real geographic risks of their portfolios” when allocating assets.

“It would be a shame if asset allocators compromised their asset allocation policy, which is often based on macro-economic scenarios that use regional dimensions, through poor evaluation of the geographic reality of their portfolio or benchmark,” the authors added.

The report also found that the total market cap of companies exposed to foreign markets rose dramatically in the 10 years to the end of June 2013. In the S&P 500, this figure grew from $2.9 trillion to $5.6 trillion.

“We thus see a clear trend for foreign geographic exposure to constitute an increasingly important part of popular regional indices, while the importance of companies with a clear focus on the official region of the index in terms of geographic exposure has decreased correspondingly,” the authors wrote.

Separate research commissioned by the Society of Pension Professionals in the UK earlier this year found that current reporting standards did not give defined contribution clients accurate information about the actual geographic exposures of their investments.

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