Asset Allocation in the Euro-Zone: Industry or Country Based?

We investigate the relative importance of country and industry factors as determinants of international equity returns in the Euro-zone over the period 1990 to 2003.We conduct our analysis from a portfolio performance perspective, using mean-variance spanning and efficiency tests as well as style analysis, and show how to adjust the tests for time varying market wide volatility.Although unconditional analysis over the full sample suggests that country-based or industry-based EMU-wide portfolios provide similar risk-return trade-offs, a rolling window analysis indicates a striking change in the structure of equity returns in the Euro-zone over the last decade.From 1992 to 1998 country-based strategies outperform industry-based strategies: country based strategies offer higher Sharpe ratios and higher diversification potential as indicated by both spanning tests and style analysis.In the preconvergence period, equity returns in the EMU-zone clearly had a country structure.In contrast, after the introduction of the Euro the country outperformance has disappeared, both in terms of mean-variance efficiency and in terms of mimicking abilities.Industry factors and country factors are now equally important.Our findings suggest that following the adoption of the single currency, Euro-zone sector-based strategies, while not dominating country-based strategies, offer similar risk return trade-offs and diversification benefits.