Market segmentation and international diversification across country and industry portfolios

We conjecture that partially segmented stock indexes that are characterized by low correlation with the world market are mainly priced by local factors and should produce abnormal returns relative to a global asset-pricing model. This implies a negative relation between correlation and future index returns in the presence of segmented indexes. Empirical evidence confirms such a relationship for the sample of industry indexes, suggesting a heterogeneous segmentation. However, we do not observe a similar pattern for country indexes. In addition, the international diversification potential of industries does not vanish during volatile periods. The hypothesis that the negative relationship should be stronger for the more segmented subsamples that are characterized by small market size and emerging country origin is verified for the industry sample. Thus, cross-industry diversification is superior to mere cross-country diversification. [Display omitted] •Segmented stock indexes with low correlation with the world index are locally priced.•These indexes should produce positive alphas from a global asset-pricing model.•This implies a negative link between correlation and future returns for such indexes.•Empirical evidence show such a link for industry indexes but not for country indexes.•Thus, cross-industry diversification is superior to cross-country diversification.