This paper introduces an alternate measure of idiosyncratic risk leveraged from the decomposition method to further eliminate the residual systematic risk inherent in the factor asset pricing model. Combining both complementary techniques contributes to a more comprehensive firm-level idiosyncratic risk that is crucial in both portfolio diversification and alpha investing. We focus our result on the idiosyncratic risk estimations and their behaviour on 36 emerging markets covering 39 industries. We show that the new measure exhibits a declining trend across time, consistent with the fact that emerging markets are becoming more integrated with the increased level of common effect across time.

This paper examines the country‐versus‐industry debate in international diversification in the context of systematic risk. We employ the popular decomposition approach proposed by Heston and Rouwenhorst and cover 2,045 individual firms from 36 emerging countries across 39 industries. Generally, we find a domination of country factors in the sample period of 1990–2012, particularly after the 1997 Asian Financial Crisis, which implies that country‐based diversification is still superior to industry‐based diversification in emerging markets. In addition, we document high variability of the common factor coupled with a diminishing trend of country and industry factors, which limits the desired risk reduction from diversification in emerging markets. A convergence between systematic and total risk is found beginning in 2007, which coincides with the timing of the Global Financial Crisis.