Ian Webster reveals that risk in European markets is currently being driven more by countries than sectors and that sector returns have become highly correlated. But a growing sector value spread may point to the next alpha opportunities

If one thing is certain in investing, it is that the investment landscape keeps changing. Over the last decade, the question of whether sectors or countries are more important as drivers of overall market risk has occupied investors' minds.

In Europe the answer to this question was typically sectors, reflecting the increasingly integrated nature of European markets. We will primarily focus on sector characteristics in this article - however, we begin by revisiting the current balance between country and sector effects in the light of recent market events.

Axioma's daily multi-factor risk modelling framework allows us to measure the risk contribution from countries and sectors simultaneously (along with other sources of risk, such as style and the market itself). Looking at the relative contribution to risk across the FTSE Developed Europe index, a trend of increasing country risk has emerged. Interestingly, this trend began before the financial crisis in 2008, though it has since been exacerbated by concerns over sovereign risk.

This trend is also seen in the cross-section of returns across countries and across sectors. Since 2010 the daily spread of European country returns has been consistently wider than that of sector returns, representing a better opportunity-set among country selection for generating returns.

Of course this is not to say that sectors are no longer relevant or can be ignored - an investor who was able accurately to forecast the relative monthly performance of European sectors could have added an active return in excess of 700bps over the same time period, using 5% active sector tilts. The key message is to understand and monitor the sources of risk in your investment portfolio and not to assume that these will remain static over time.

Axioma has been commentating for some time now on the impact of increasing correlations within equity markets. These spikes in correlation are particularly notable in periods of extreme volatility where assets tend to move in unison. High correlations diminish the potential advantages of diversification and make it very difficult for active stockpickers to differentiate themselves form their peers.

This cyclicality in correlation is observed at the sector level as well as the individual asset level. In recent times, short-term regional European sector correlations have been as high as 0.90.

One way to see the impact of correlation combined with volatility is to look at the spread of sector betas.

This short-term beta measure illustrates a recent period of beta compression, driven by a combination of uniformly high volatility across sectors and high correlations. Sector beta spreads remained relatively low during the extreme market volatility of 2008 for many of the same reasons.

A forward-looking view on sector beta based on the Axioma fundamental risk model is shown in the table above.

The reader may be left wondering what other characteristics are differentiating sectors at the current point in the cycle. We can look at style biases within sectors to help answer this question.

The figure shows the value spread between European sectors over time, with the top and bottom lines representing the highest and lowest value exposure across sectors. We observe that the value spread has been widening again since mid-2009. Admittedly this is driven to a large extent by the financial sector, however, history tells us that extreme value premiums among these sectors do not persist indefinitely and so we can expect a re-rating (either in prices or valuations) once the current macro influences subside.

In summary, to manage (and take advantage of) risk effectively requires a clear understanding of the drivers of risk. Changing sources of risk, changing correlations and changing risk exposures mean that the practitioner must constantly be monitoring the implications for their portfolio.

Ian Webster is managing director of Axioma EMEA, a risk management, portfolio construction and analytics firm