Factor reversal in the euro zone stock returns: Evidence from the crisis period

• This paper uses three different methods to investigate changes in the relative importance of industry and country factors driving euro zone equity returns in the recent crisis period.
• Factor reversal has occurred whereby country effect has become more important than industry effect during the crisis period.
• The observed euro zone factor reversal appears to have stemmed from countries with weak macroeconomic fundamentals.
• Deteriorating macroeconomic fundamentals, high institutional and sovereign risks are capable of explaining this factor reversal.

The adoption of the euro led to a shift in importance from country to industry effects in euro zone stock returns. For the first time, this paper shows that country effects have regained importance in the recent spate of crises. This euro-wide factor reversal is driven by countries with poor economic fundamentals, comprising Portugal, Italy, Ireland, Greece, and Spain (PIIGS). The results imply that a more traditional country portfolio approach provides greater diversification benefits during crisis periods and the minimum-variance frontier of industry portfolios in PIIGS countries can be improved by adjusting country weights.