Factor Investing in International Markets

The factor premium—the excess return earned by holding stocks with particular traits like low valuations, high profitability, or strong momentum—is well documented in US equities. Whether these premiums persist in London, Tokyo, or Hong Kong is trickier. Evidence shows that value and quality premiums are weaker but real abroad; momentum is capricious; and emerging markets behave like a third asset class entirely, requiring separate frameworks.

The replication question

A US-based factor investor observing that value stocks outperformed growth by 3–5% annually over 20 years naturally asks: does the same premium exist in the UK, Germany, or Japan? If so, a global factor-investing strategy can diversify across regions and exploit the premium everywhere. If not, the premium may be an artifact of US market structure or history, with no guarantee it persists domestically or travels internationally.

Academic research, notably by international asset-pricing scholars, has tackled this question systematically. The findings are sobering. Value, momentum, and quality premiums exist in most developed markets, but they’re smaller, noisier, and less persistent than in the US. In emerging markets, the picture is murkier still: premiums may exist for a time, disappear, then reappear in a different guise.

Developed market factors: the evidence

Value premium. Low price-to-book and low price-to-earnings stocks do tend to outperform high valuations in the UK, Germany, Switzerland, and other developed markets. But the premium is typically 1–3% annually, versus the 3–5% observed in the US. The premium is also more volatile and less consistent across time periods. Value was strong from 1980–2007, then collapsed for over a decade in the US and most developed markets (2007–2018), before rebounding. Different countries experienced this drawdown at different intensities and times, suggesting that local factors—regulatory changes, demographic shifts, pension fund behaviour—matter as much as universal forces.

Momentum premium. In the US, holding winners (past 12 months) and shorting losers has historically yielded returns. In developed markets outside the US, momentum is unreliable. European momentum premiums are real but smaller and more volatile. Japan shows weak-to-negative momentum for much of the post-1990 period. This inconsistency may reflect lower trading liquidity, slower information diffusion, or different behavioral patterns across markets.

Quality premium. Profitable, stable firms with high return-on-equity outperform in most developed markets, but again the edge is muted. Profitability is harder to measure consistently across geographies (accounting standards vary). A high-ROE firm in German family-owned manufacturing may behave very differently from a high-ROE US tech company. And “quality” traits—like low volatility—can be crowded in some markets (especially among pension funds), eroding premiums.

Currency complications

A major wedge between US and international factor premiums is currency. When a US investor holds a German value stock, her return comprises two parts: the stock’s local-currency return plus the euro’s appreciation or depreciation against the dollar.

Currency moves are large and somewhat unpredictable. Over a year, the euro might appreciate 8%, masking or amplifying the stock’s underlying performance. Many research papers on international factor premiums do not explicitly adjust for currency; the reported return includes FX moves, conflating factor premium with currency bet. This is fine for investors who actually take currency exposure (i.e., unhedged), but it muddles cross-border comparison.

A cleaner approach: researchers report factor returns in both local currency (what a local investor would earn) and USD (what a US investor would earn unhedged). Usually the factor premium itself—the local-currency return—is real but modest. Currency is noise on top.

Emerging markets: a separate category

Emerging-market equities are a different beast. Data quality is poorer (accounting standards lag, corporate disclosure is spotty). Liquidity is lower, so trading costs for factor-based trades are high. Political and macroeconomic risk add significant idiosyncratic noise. And factor patterns documented in developed markets don’t translate cleanly.

Some research finds value premiums in emerging markets at certain periods, but they’re inconsistent. Momentum occasionally works, then reverses sharply (common in high-beta, speculative markets). Profitability and growth factors are weaker. The sheer diversity—Brazil, India, Russia, Thailand, each with different economic structures, regulations, and investor bases—means that factors that work in one emerging market flop in another.

Practitioners treating emerging markets as a monolith often disappoint. Those who differentiate by region (Latin America versus Southeast Asia versus emerging Europe) and adjust factor definitions locally fare better.

Why premiums diverge across regions

Several explanations:

Market structure. The US stock market is deep, liquid, and efficient. Smaller, illiquid developed markets allow mispricings to persist longer, but also suffer from higher trading costs that offset the premium. Emerging markets face both stale mispricings and high transaction friction.

Behavioral and institutional factors. US pension funds and endowments may be more prone to certain biases (extrapolating growth, herding into momentum) than, say, Japanese institutional investors or German bank-dominated markets. Different investor bases behave differently.

Data and survivorship bias. Earlier factor studies relied on limited, hand-collected data for non-US markets. Survivors—markets and firms that continued to exist—are overrepresented; delisted stocks (often poor performers) are omitted. This survivor bias inflates observed premiums. As data quality has improved, some claimed premiums have shrunk.

Factor definitions travel poorly. A “value” stock in the US might mean low P/E and high dividend yield. In Japan, where buybacks are uncommon and dividends customary, that definition catches a different set of firms with different risk profiles. Researchers often have to localize factor definitions, and when they do, premiums change.

Practical implications for global factor investing

Diversification is limited. If a global portfolio goes long value worldwide, it’s making one big bet that value will outperform globally. Regional divergence in factor premiums means diversifying across geographies doesn’t reduce the volatility of the factor exposure the way it might reduce idiosyncratic risk.

Costs matter more. In the US, low-cost factor indices exist; a value investor can build a factor exposure cheaply. In international developed markets, costs are higher. In emerging markets, they’re substantially higher. These costs eat into the already-modest premiums, so only investors with high conviction and low costs can profit.

Tactical adjustment is essential. A global factor manager who treats all value opportunities as equal will underperform peers who adjust exposure by region. In periods when US value is depressed but Japanese value is strong, a flexible manager overweights Japan. This requires regional expertise and frequent rebalancing.

Currency hedging is a choice, not neutral. Taking unhedged international factor exposure means embedding a currency bet. For some investors, that’s acceptable; others hedge it away. The choice affects realized returns and should be explicit.

See also