Country v Sector Effects in Equity Returns: Are Emerging-Market Firms just Small Firms?

In the debate whether country factors are typically more variable than sector factors, sparked off by e.g. Roll (1991) and Heston and Rouwenhorst (1994), one of the few uncontested facts is that the addition of emerging markets (EMs) does boost the ratio of country-factor variance relative to industry-factor variance. Emerging markets do tend to have a higher variability but simultaneously are less related to global market and industry factors. We investigate to what extent this phenomenon can be traced to the impact of adding more small firms. We find, first, that small firms do have higher volatility, but one needs to control for country and sector affiliation before that becomes visible. We next find that small firms do have weaker sector affinity, as expected. Third, small firms unexpectedly have weaker local-market sensitivities than large firms. Facts 2 and 3 mean that adding more small firms to the data base has a diversifying effect on both the sector- and country-factor variance; and while the impact on sector variance is larger, the net effect turns out to be tiny. Fourth, adding emerging markets has a very marked impact on the variance ratio. In fact, the addition of small stocks to the sample hardly dents the effect of adding EMs. Thus, the role of emerging markets cannot be reduced to just a small-firm phenomenon