Country v industry factors in equity returns: (When) do non-unit exposures matter?

The Heston-Rouwenhorst (HR) estimates of country and industry factors have been criticised for assuming that each stock has unit exposures to its own country and industry factor. We address this issue analytically and empirically. Our position is that HR are not modeling and estimating a return generating process. Rather, they provide an algorithm for linearly combining pre-defined s tandard country and sector portfolio returns such that the effects of different sector weights in country indices (and vv) are taken into account. This is valid in itself, just like it makes sense to compute a valueweighted or equally- weighted market return even when we know that stocks’ betas are probably different from unity. In addition, we find that a Fama-MacBeth variant of HR, which does allow for non-unit exposures, produces nearly identical factors as the original version. Allowing for non-unit exposures does make sense, though, if the purpose is to estimate a stock’s return-generating process, for instance in an event study, or if one wishes to study the analog of _2 j var(˜rm), the variance generated by the market factor in an individual stock, rather than var(˜rm). If this is the purpose, the relative importance of country factors grows, and even more so if one corrects for the effects of estimation error in the exposures. In fact, exposures to industry factors are surprisingly low—about 0.30 instead of over 0.90 for world and country factors.