Market segmentation scores and portfolio diversification

Portfolio diversification is often associated with negative correlation in asset returns. Correlation coefficients are important but they are too simple to rely on. Moreover, it is not always necessary to have negative correlation to benefit from diversification. Many funds, tactical or strategic, can attest that diversified portfolios do not require strict use of asset return correlation matrices. We recommend use of Segmentation Scores instead. This short note describes the methodology and how it works in practice. We use international diversification to introduce the subject but the use of segmentation scores methodology is much broader. We welcome comments.  

International diversification revisited

Investors have two objectives when they diversify and especially when they diversify internationally. First, there is always the potential of generating higher returns than a portfolio investing only in home country assets can. Second, domestically systematic risk, which is locally undiversifiable, becomes diversifiable when invested internationally. This is because systematic risk defined against a national market becomes idiosyncratic and hence diversifiable against an international portfolio of risky assets, which also enhances risk-adjusted returns.

The more segmented a target (foreign) market from the rest of the world or from home is, the larger would be the benefits from diversification. Thus, segmented markets, that is those markets with low beta risks against a global benchmark portfolio, offer attractive investment opportunities and significant diversification benefits. 

The markets of all jurisdictions are segmented albeit at varying degrees. The key differentiating factor here should be the degrees of segmentation from a benchmark market against which all markets around the globe are defined. Linking the choice of risky assets to degrees of market segmentation indeed adds a decision-making tool to the host of other metrics a portfolio manager may have at her disposal. The challenge for the money manager seeking opportunities around the Globe is to balance the investment risks present in segmented markets with the rewards these markets potentially offer.

Segmentation scores and country choice

We suggest a convenient statistical measure to help sort investable equity markets based on their potential diversification rewards. We propose using cross sectional comparison of degrees by which the local markets are segmented from a benchmark global market portfolio. We label this particular tool segmentation score borrowing the term we have introduced in an earlier work in the finance literature (Akdogan, 1996). Segmentation scores help portfolio strategists and fund managers rank countries based on their diversification merits and use the rankings to reduce and tailor the opportunity set.  

How do we obtain the segmentation scores? The relevant measure of market segmentation is a country's (foreign market's) contribution to world systematic risk relative to its contribution to world market value.

In a single-index convention, we estimate segmentation scores as follows.

A = BETA(i)^2 x SIGMA(w)^2 / SIGMA(i)^2

B = MCAP(i) / MCAP(w)

where                                                          

BETA(i)2 = Foreign Market's Beta squared

SIGMA(w)^2 = Return Variance of the World Market Portfolio

SIGMA(i)^2 = Return Variance of the Foreign Asset

with 0 < A < 1; 0 < B < 1.

High A or low B ratios suggest high degree of market segmentation.

The underlying assumption here is that segmented markets should and will contribute less to world systematic risk than to world market value. Thus, the metric we use for market segmentation is "the share of systematic risk in total risk" relative to "the share in word equity market capitalization." Relative segmentation scores offer more robust criteria than simple correlation coefficients, co-variances and betas do. 

Scores of market segmentation can also be used to monitor the risk diversification merits or demerits of stock markets against a global benchmark. The empirical tests we have carried out do indeed show that segmentation scores methodology is as relevant and functional over time as it is across markets.

Segmentation scores and choice of risky assets

Systematic risk in a specific (individual) risky asset relative to the contribution of the same asset to total equity market capitalization of investable assets is equally useful for individual assets. Market integration analysis ranks individual securities based on their segmentation scores, which adds to the list of metrics money managers use to form an investment decision. Securities with higher segmentation scores offer greater potential for higher returns. Each risky asset or asset class has both local and global systematic risk exposures. A higher (lower) exposure to global systematic risk indicates a higher (lower) degree of segmentation with the world market and lower (higher) diversification benefits.

Summary and conclusion

The specific measure we have proposed is a country’s systematic risk contribution to the global benchmark market portfolio in that a growing contribution implies a greater integration of the local market. The countries are then ranked according to their systematic risk contributions and the funds are committed following a program which uses segmentation scores relative to market weights. The approach we have summarized here also helps money managers develop trade recommendations by monitoring changes in segmentation scores. 

References

Akdogan, Haluk (1996) - A Suggested Approach to Country Selection in International Portfolio Diversification, Journal of Portfolio Management

Akdogan, Haluk (1997) - International Security Selection under Segmentation: Theory and Application, Journal of Portfolio Management.