Why Country Selection Matters

The answer to a chicken-or-egg question.

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Do strong economies breed successful companies? Or is it the other way around? It's the chicken-or-egg question of international finance, and it has stumped mutual fund investors for decades.

According to some recent number crunching by Federated Investors, though, the answer is quite clear: The fund company found that in a diversified international portfolio, between 70 and 75 percent of investors' returns stem from country allocation rather than individual stock selection.

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"The stock-specific risk declines with the more stocks that you have to become a very small portion of your overall portfolio risk because it cancels out, and what you are left with is primarily country risk," says Audrey Kaplan, a comanager of the Federated InterContinental Fund. "Another way to think about it is that you're not holding 15 percent in any single stock, but you may be holding 15 percent in a country."

According to Kaplan, the issue of country selection (which includes currency exposure) is particularly relevant in the current economic climate. After the recession hammered almost the entire global economy, countries responded with a wide range of policy decisions, some of which have obviously been far more successful than others.

The countries that Kaplan currently favors include China, Brazil, Chile, Norway, and Denmark. As an example of how country selection can overshadow stock picking, Kaplan points to Norway. "Because of the low level of unemployment there, especially compared to other developed economies, domestic consumption and retail sales have been surging," she says. This, in turn, has helped a wide range of Norwegian companies.

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Kaplan has also found that a number of emerging markets are healthier than their developed peers. "There are many economies now that are classified as 'emerging' that are actually in a stronger financial position—the governments—compared to the developed economies. And the reason [for that] is for 20 years now, not only have individuals been borrowing too much, but governments of certain countries have been borrowing too much," she says.

The main implication of Federated's findings is that they challenge the traditional bottom-up approach to international investing. Most international funds look first for individual stocks and treat country selection as only a secondary decision. Kaplan, on the other hand, takes a top-down approach.

There are, of course, times when other factors take on increasing prominence. When tech stocks soared in the late '90s, for instance, choosing the right industry was arguably more important than finding the best country. "There was a lot of debate at that period about if we were moving into a new paradigm," she says. "[But] we found that was a temporary phenomenon."