There is a certain exotic appeal to investing in foreign markets. Yet, as with investing in domestic stocks, adding foreign exposure to your portfolio involves risks. Country betas provide some insight to the magnitude of the risk, especially for those who use country exchange traded funds (ETFs). Although country betas in many parts of the world seem moderate, investors should not be lulled into a sense of complacency.
I recently set about calculating country betas, based on the MSCI country indices. (A brief introduction to country betas and how I calculated them is found in Evaluating Foreign Market Risk.)
I examine three categories of economic development: Developed Markets, Emerging Markets, and Frontier Markets. It is interesting to see how markets at different stages of development move in relation to each other.
I examine rolling five-year betas, based on monthly returns of the MSCI Country indices. Let's focus on April's numbers for a moment.
One of the first characteristics that we note is that the average beta in the Developed Market group is right around unity; it is 1.02. This should not necessarily be surprising, as these countries have long served as the "market."
Emerging Markets are often considered more volatile. But this does not necessarily seem to be the case now, as the average beta for this segment is 1.01. Meanwhile, the Frontier Market group has an average beta of 0.89. These groups are actually "safe" then, right? Figure, the Emerging Markets have made such great gains integrating into the global financial and economic systems, investing there is no riskier than investing in the Developed Markets. Right? Not necessarily.
The currently innocuous betas of the Emerging Market and Frontier Market groups need to be weighed against their historical performances. The graph below shows the rolling five-year average betas for these three market groups (Developed Market, DM; Emerging Market, EM; and Frontier Market, FM).
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We know that there are several "flaws" or shortcomings associated with betas. For instance, beta is calculated on historical performance numbers, and performance changes. We see that this is the case across all three groups, as the average betas have fluctuated over time. What is particularly interesting is how the Emerging Market group has approached unity with the World Market (average beta close to 1.00) in the past, right around the time of various financial crises, such as those experienced in the mid-1990s, late 1990s, and 2008. (Does this then support the old adage that, during periods of crises, all correlations go to one?)
Another dynamic that is particularly interesting is the volatility of the beta for the Frontier Market.
Of course, it is also worth noting that betas within the same category can vary considerably. For instance, consider Greece, a Developed Market country. The beta of the MSCI Greece Index relative to the MSCI World Index has increased substantially since the middle part of the last decade, as that country's fiscal position has deteriorated.
(Click to enlarge)
That stated, it is worth examining the variance of the betas within the different market groups. This is shown in the graph below.
We see that the dispersion of the betas within the Developed Market group remains tight. But, the relatively volatile nature of the Emerging Market and Frontier Market groups comes to light, as we see substantial differences within those categories.
Another factor that is also noteworthy is how the variances within the groups have consolidated in recent years, coinciding with the global financial crisis. Not only do we see that, on average, there is convergence among the countries within their respective groups, but we also find convergence across all the groups. This consolidation raises some questions about economic growth and stock market performance globally as countries continue to work their way through a recovery.
There are benefits to investing in foreign markets, particularly emerging markets. But there are also risks. Investors lured to exposure to foreign markets in general and emerging markets in particular by the currently relatively benign betas should, nonetheless, approach this arena with some trepidation. Given the historical tendency of betas for the Emerging Markets and Frontier Markets to deviate from the Developed Market (and, on a country level, from each other), we should not be surprised to find a similar dynamic in the future, particularly if rates of economic growth differ considerably.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.