The Evolution Of Diversification


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This article examines four key trends that have influenced the concept of diversification, and considers the implications on modern-day portfolios and investors.

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The Evolution Of Diversification

  1. 1. THE EVOLUTION OF DIVERSIFICATIONThe World Is Evolving; Portfolios Should Evolve, TooInvestors diversify in an effort to mitigate the impact of market fluctuations on their portfolio returns. Over time, this produces asmoother overall investment experience – one that helps strike a balance between growth and safety. The theory of diversificationsuggests that this is achieved by holding a mix of investments across various industries, regions and asset classes.The way investors achieve diversification has changed over the past 20 years, largely due to globalization and productinnovation. In a modern-day context, being effectively diversified has taken on new meaning and a new level of importancegiven globally integrated economies and close linkages across capital markets.The major inputs to global economic growth continue to evolve, and increasingly, these changes are reflected in the makeupof global capital markets. It is critical that portfolio construction also evolve to reflect this. Diversification today means havingexposure to opportunities in fast-growing emerging markets, investing in both large and small companies, incorporatingdifferent investment styles, and holding a broader range of fixed income investments.In this article, we will examine four key trends that have influenced the concept of diversification: 1. Globalization 2. The rise of emerging markets 3. Multiple layers to equity investing 4. Broader horizons for bondsWe will consider the implications for investors and how these trends affect modern-day portfolios. 20 Years Later, Opportunities for Investors to Diversify are Significantly Different Diversification Diversification Implications for 1992 2012 Portfolio Diversification Geographic Canada Sectors U.S. Equity portfolios can benefit from more Stocks Investment styles Europe than just a good country mix Market capitalization Japan Emerging markets Federal Provincial Municipal Government Investment-grade Bond portfolios can benefit from Bonds Corporate corporate incorporating additional investment options High-yield corporate Emerging markets Convertibles 1
  2. 2. 1. GlobalizationFree trade between countries, increasing foreign investment, and an increasingly global environment have created greaterlinkages between countries, particularly in the developed world. Financial innovations now make it easier for investors to accessglobal capital markets but have also increased linkages in risk across different regions. Statistically speaking, the correlationbetween global economies has posed new challenges for achieving effective diversification.Markets that are highly correlated tend to respond to changes in the business cycle by moving in the same direction and tothe same degree. The opposite is true for markets that are uncorrelated or inversely correlated. This principle of combininginvestments that are uncorrelated or inversely correlated is precisely the approach that underpins the theory of diversification.We saw the power of positive correlation in action during the global financial crisis of 2008/2009 when global equity marketsdeclined sharply following news of Lehman Brothers’ bankruptcy on September 15, 2008. What started out as the bust of theU.S. housing bubble evolved into a financial crisis and emerged as the first simultaneous economic recession in the U.S., Japanand Europe since World War II.For many investors, the financial crisis was a wake-up call that simple diversification across developed regions no longeroffered the same benefits of risk mitigation that it had in the past. The convergence of growth patterns over the past 20 yearsconfirms this. Global Economies Now More Linked Than Ever 1.0 0.8 0.6 More Linked 0.4 Less Linked 0.2 0.0 Correlation -0.2 -0.4 -0.6 Correlation of largest Correlation of Largest 50 Countries 50 countries’ economic Economic Growth vs World GDP -0.8 growth vs world GDP (10-year rolling) -1.0 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 Source: World Bank, 10-Year Rolling Returns.Sector and market-cap diversification are still strong reasons to diversify, but these higher correlations mean that thisapproach alone will not provide the same level of downside protection it may have in the past. This is why addingbroader exposure to various geographic regions has become increasingly important. 2
  3. 3. Diversification in 1989... Five years ended December 1989 25 100% International Equities 20 100% U.S. Equities Old Portfolio: 15 Return (%) 50% Canadian Equities 25% U.S. Equitiesquities 25% International Equities 10 100% Canadian Equitiesquities 5Risk 0 Lower Risk Higher Risk 6.0 0.0 1.0 2.0 3.0 4.0 5.0 6.0 Risk (Standard Deviation) Source: Morningstar Direct, Risk/Return – Ten years ended December 1989. ...May Not Be the Best Solution Today Five Years Ended December 2010 25 25 20 20 15 15 Return (%) Return (%) New Portfolio: 100% Emerging Markets Equities 25% Canadian Equities 10 25% U.S. Equities 10 Old Portfolio: 100% Canadian Equities 25% International Equities 25% Emerging Markets Equities 50% Canadian Equities 5 25% U.S. Equities 5 100% U.S. Equities 25% International Equities 100% International Equities 0 Lower Risk Higher Risk 0 0.0 1.0 2.0 3.0 4.0 5.0 6.0 Risk (Standard Deviation) Source: Morningstar Direct, Risk/Return – Ten years ended December 2011. 3
  4. 4. 2. The Rise of Emerging Markets The makeup of economic activity around the world has changed. Twenty years ago, nearly 50% of global production came from the U.S. and Europe, compared to approximately 35% today. The share of output from developing countries in regions such as Asia has more than doubled over this same time period, from 10% in the early 1990s to nearly 25% today. In fact, emerging markets now make up over 80% of the global population and are the world’s fastest-growing economies. Developing Asia Contributing More to Global Production 26 24 22 20Share of World Output (%) 18 16 14 United States Euro Zone 12 Developing Asia 10 1992 1995 1998 2001 2004 2007 2010 Source: IMF World Economic Outlook, PPP Basis. Just as globalization has shaped the breakdown of world GDP, new technologies have reshaped the face of investment opportunities. Established companies in mature industries are embracing change and fast-tracking innovative capital investments, and most of this innovation is occurring outside of the places where we’re used to investing. For example, even though the U.S. still leads the world in terms of global expenditure on research and development, Asia’s spending has been steadily growing in the past decade to the point where China has assumed second place globally, ahead of Japan. 4
  5. 5. Emerging Markets: The New Economic PowerhouseFuelled by a strong desire for economic expansion, many emerging markets are increasingly opening their doors to foreigninvestment. These countries have continued to develop trading relationships with the rest of the world and are in the process ofunleashing the economic drive of young, skilled and highly motivated workforces. These countries are playing an increasinglyimportant role in global growth and in investor portfolios.The level of global GDP made up by emerging markets has grown considerably since the mid-1960s – a trend that’s expectedto continue in the coming decades. By contrast, developed markets’ share of global GDP has been declining. Since 1987,America’s contribution to overall global GDP levels has dropped from over 30% to less than 27%. China, which didn’t evenregister in the Top 10 back in 1987, has since surpassed every European country to take the number 3 spot behind Japan.It’s estimated that by 2030, nearly 16% of the world’s GDP could come from China. Given this progress, it’s no surprise thatthe economic improvements in emerging markets have led to two decades of rapid growth and strong returns for emergingmarket equities. An effectively diversified portfolio allows an individual investor to tap into the growth potential of these marketsgoing forward. Emerging Markets Contributing More to Growth Top 10 Economies: Past, Present and Future? Rank 1987 2010 2030* % World % World % World Country Country Country Economy Economy Economy 1 United States 30.1% United States 26.1% United States 22.8% 2 Japan 16.2% Japan 8.6% China 15.5% 3 Germany 6.6% China 7.9% Japan 5.2% 4 United Kingdom 4.9% Germany 5.8% Germany 4.3% 5 France 4.5% United Kingdom 4.5% India 4.2% 6 Italy 3.9% France 4.4% United Kingdom 3.7% 7 Canada 2.3% Italy 3.3% France 3.3% 8 Brazil 2.1% Canada 2.5% Brazil 2.6% 9 Spain 1.8% Brazil 2.4% Russia 2.4% 10 Russia 1.7% India 2.4% Italy 2.3% Source: World Bank, USDA. *Projected. Measured by GDP. What’s driving growth in emerging market economies? Free markets – By adopting more liberal economic policies and free-market ideas, emerging markets have unlocked the economic potential of billions of people who are eager to join the ranks of developed nations. Strong trade surpluses – High demand for emerging markets’ export goods has funded the emerging market governments with strong foreign earnings and extremely high levels of foreign currency reserves. The opposite trend has occurred in developed markets. Low debt levels – By and large, governments, consumers and corporations in emerging markets carry much lower levels of debt than their counterparts in developed markets. More young, skilled workers – As developed markets face a declining number of working adults in the future, emerging markets benefit from a younger workforce that will continue to grow. 5
  6. 6. 3. Multiple Layers to Equity InvestingIndividual investors have more choices and opportunities than ever before. Across the spectrum of asset classes and geographicregions, portfolio diversification can be enhanced by looking at small and large companies across different sectors and withvery specific characteristics. Investors today have greater access to a far more robust set of opportunities, and these will play anincreasingly important role in portfolio performance in the future.Diversifying by Market CapitalizationWhile smaller-cap securities are inherently more volatile than their larger-cap peers, low correlations illustrate a clear benefitto including both in a diversified portfolio. This is mainly due to the fact that over time, small- and large-cap stocks haveperformed differently.Smaller companies tend to perform well in the early stages of economic recovery, with large caps leading the way as theeconomic cycle starts to mature. This was the case following the market bottom in March 2009, with large-cap stocks onlyrecently beginning to perform more in line with small- and mid-cap names.Analyst coverage is another reason why smaller companies offer unique investment opportunities. Approximately 10,000companies trade on major U.S. exchanges; however, only about 1,000 of the largest are closely followed by analysts andmarket watchers. As a result, many smaller companies that present excellent investment opportunities are often overlooked.Careful investments in smaller companies can provide the opportunity to purchase high-quality businesses at a lower multiplethan one would have to pay to purchase a larger, well-known company of similar quality. Small and Large Companies Will Outperform at Different Times Over the past 30 years, large companies have outperformed small companies on a monthly basis 50.3% of the time. 20.0 Large Companies OUTPERFORM Small Companies 15.0 10.0 5.0 Return (%) 0.0 -5.0 -10.0 -15.0 Small Companies OUTPERFORM Large Companies -20.0 1979 1983 1987 1991 1995 1999 2003 2007 2011 Source: Russell Investments. Data as of Jan. 1, 1979 – Feb. 29, 2012. Small companies represented by Russell 2000 TR Index. Large companies represented by Russell 1000 TR Index. 6
  7. 7. Diversifying by SectorInvestors can tap into another important layer of diversification by investing in companies that operate in different industries.This is especially important for Canadian investors. Canada has distinguished itself as a global leader in several sectors,including Financials, Energy and Materials. However, these sectors represent more than 75% of our market. By comparison,U.S. and international markets have a more balanced sector mix that incorporates a wider range of industries. For example,Information Technology, Consumer Discretionary and Health Care sectors make up close to 40% of the U.S. market but less than10% in Canada. Sectors Canada U.S. International Financials 28.0% 15.8% 24.0% Energy 27.7% 13.3% 8.5% Materials 22.6% 3.7% 11.3% Industrials 5.4% 11.3% 13.1% Consumer Discretionary 4.2% 10.4% 10.2% Telecommunications Services 4.3% 3.0% 5.6% Information Technology 2.4% 18.1% 4.8% Consumer Staples 2.4% 10.2% 9.7% Utilities 1.7% 3.2% 4.8% Health Care 1.1% 11.0% 8.0% % Index Weight of Top 3 78.3% 47.2% 48.4% Source: Morningstar. Data as of March 31, 2011. Canada represented by SP/TSX Composite, U.S. represented by SP 500, International represented by MSCI EAFE. All in C$.Diversifying by Investment StyleInvestment style generally refers to the way money is managed and is reflected by the type of securities held in a portfolio. Thetwo styles most commonly referred to are growth and value, and together they provide excellent diversification benefits. Styles Outperform at Different Times Growth $600 • rowth investors generally look for G Russell 3000 Value TR Growth stocks far outperformed value stocks through the 1990s technology-driven market. companies with strong prospects for 550 Russell 3000 Growth TR However, value has outpaced growth by a wide margin over the past decade. above-average earnings growth in 500 revenue and earnings. 450 • rowth stocks tend to perform G 400 better during periods of strong economic expansion.Value 350 300 250 Value • alue investors seek companies trading V 200 at prices that don’t reflect their financial 150 strength or future prospects. Value 100 stocks are typically characterized by high 1995 1998 2001 2004 2007 2010 dividend yields and strong free cash flow. Source: Russell Investments. Investment growth, based on $100 investment in • ecause value stocks often have B February 1995. Data as of Feb. 27, 1995 – Dec. 30, 2011. relatively stable earnings, this approachAlthough an investor may be inclined to rotate from one style to the other tends to outperform during periods whendepending on market conditions, being invested in both growth and value economic activity is moderating.eliminates the risk of trying to time the market. 7
  8. 8. 4. Broader Horizons for BondsOver the past 20 years, different types of bonds have outperformed as inflation and interest rates fluctuated with changingeconomic conditions. As with equities, gauging which segment of the bond market will outperform in any given year cannot bereliably predicted. By combining different types of bonds in a portfolio, investors have been able to achieve a meaningful boostin returns with only a marginal increase in volatility.The Many Segments of the Bond MarketHistorically, government bonds were the primary holding within most fixed income portfolios. That is no longer the case. Asinterest rates declined over the past 20 years, fixed income investors have continued to seek new solutions that offered higheryields. During this period, high-quality corporate bonds have become an increasingly important part of many investor portfolios.Today, investors have access to an even wider range of choices that provide both higher yields and more importantly, greaterdiversification potential. A Mix of Different Bonds Can Provide a Better Investment Experience Returns on Different Fixed Income Investments: 2006 – 2011 2006 2007 2008 2009 2010 2011 1.7% 2.4% 1.2% 1.3% 2.4% 2.3% 9.6% 5.1% 11.5% 44.5% 14.4% 10.8% U.S. High Yield Emerging Canadian U.S. High Yield U.S. High Yield Global Bonds Markets Bonds Federal Bonds Bonds Bonds Corporate Bonds 8.7% 4.9% 9.6% 28.5% 12.3% 9.7% Emerging Global Global Emerging Emerging Canadian Markets Bonds Bonds Bonds Markets Bonds Markets Bonds Bonds 4.1% 4.6% 8.6% 18.0% 9.4% 8.4% Canadian Canadian Canadian Global Global Canadian Bonds Federal Bonds Short-term Bonds Corporate Bonds Corporate Bonds Federal Bonds 4.0% 6.4% 5.4% 6.7% 7.7% 4.3% Canadian Canadian Canadian Canadian Emerging Cash Short-term Bonds Bonds Bonds Bonds Markets Bonds 4.1% 4.5% 5.4% 6.5% 3.9% 2.6% Canadian Canadian Canadian Global Cash Cash Short-term Bonds Short-term Bonds Federal Bonds Bonds 3.6% 3.7% -5.8% 1.1% 3.8% 5.0% Canadian Canadian Global Global Global U.S. High Yield Federal Bonds Bonds Corporate Bonds Bonds Bonds Bonds 3.2% 3.7% -13.9% 3.6% 4.7% 0.4% Global Global Emerging Canadian Canadian Cash Corporate Bonds Corporate Bonds Markets Bonds Short-term Bonds Short-term Bonds 2.1% 1.5% -25.7% -0.2% 0.4% 0.9% Global U.S. High Yield U.S. High Yield Canadian Cash Cash Bonds Bonds Bonds Federal BondsSource: RBC Global Asset Management Inc. Data: Jan. 1, 2006 - Dec. 31, 2011. Emerging JP EMBI Global Diversified U.S. High Yield Bank of America Merrill Lynch US Annual Inflation Bank of Canada Markets Bonds (CAD Hedged) TR Bonds High Yield BB-B (CAD Hedged) TR DEX 30-Day Treasury Canadian Short-term DEX Short-Term Bond Citigroup World Global Bond Cash Global Bonds Bill Index (CAD) TR* Bonds Index (CAD) TR Index (CAD Hedged) TR DEX Universe Bond Canadian Federal DEX Universe Federal Global Corporate BARCAP US Corporate Investment Canadian Bonds Index (CAD) TR Bonds Bond Index TR Bonds Grade (CAD Hedged) TR*TR represents total return 8
  9. 9. High-Yield Bonds Lower Risk AAASimilar to other corporate bonds, a high-yield bond offers a way for investors AAto lend money to a company in return for regular interest payments and Investment Aprincipal at maturity. The “high-yield” label indicates a relatively lower credit Grade BBBquality, which is a measure of financial strength reflected in the ratings issuedby agencies such as Moody’s, Standard Poor’s and Fitch. BB BThese agencies assign credit grades on a sliding scale based on their judgment High Yield CCCof the issuer’s ability to pay interest and principal as scheduled. As a group, CChigh-yield bonds are typically rated below BBB. Higher Risk CHigh-yield bonds provide investors with the opportunity for high absolutereturns and low correlation with other asset classes over the long term. The high-yield bond market has become an increasinglypopular source of financing for many reputable companies and represents a significant portion of the total fixed income market.By the end of 2010, the U.S. high-yield bond market alone was worth close to $1 trillion.Emerging Market BondsEmerging market bonds typically pay higher yields than investment-grade bonds issued by developed countries such as Canada.This extra yield is essentially a “risk premium,” which means that investors are compensated for the added risk of investing incountries that have shorter records of sound economic policies and less-established institutional and government frameworks.Today, many emerging market governments are in better shape financially than their developed market counterparts onseveral measures of economic health, including growth rates, financial capacity and overall debt levels. Also, more than 50%of emerging market government bonds are rated investment-grade by independent rating agencies, meaning that they are ofreasonably high quality. Over 50% of Emerging Market Bonds Are of Investment-Grade Quality Credit Ratings of Emerging Market Debt 100% 0.8% 6.3% 8.9% 90% 10.3% 80% 33.9% 70% 60% 50% 73.6% 40% 30% By June 2011, 56.4% of emerging market bonds 56.4% 20% were investment grade. In 1998, 9.8% of emerging market 10% bonds were investment grade. 9.8% 0% 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 Source: J.P. Morgan, EMBI Global Index Credit Composition. Data as of Dec. 31, 1998 – June 30, 2011. CCC and not rated B BB BBB and higher 9
  10. 10. Convertible Debentures Convertible debentures are hybrid investments that have characteristics of both fixed income and equity securities. A convertible debenture pays regular coupons and gives an investor the option to convert the bond into shares of a company. Thus, investors receive a regular income flow through the coupon payments plus the ability to participate in capital appreciation through the potential conversion to equity. Convertible debentures are normally subordinate to the company’s senior debt. Compared to equities, convertibles have some distinct differences. As they are initially bond investments, investors have a greater claim on the firm’s assets in the event of bankruptcy than equity shareholders, while the income flow is more stable than dividends because coupon payments are a contractual obligation. Finally, convertible bonds offer both protection in bear markets through regular bond features and participation in bull markets through the conversion option.Why a Mix of Different Bonds WorksOver time, the performance of different bonds reflects the risk assumed by investors – that’s why government bond returnstypically lag corporate, high-yield and emerging market debt. But in terms of diversification, the benefit of holding various fixedincome securities becomes clear when investors assess performance across the interest rate cycle. During periods when interestrates are rising, high-yield and emerging market debt tends to perform well compared to government bonds. There are severalreasons for this: • Interest rates typically rise in a strong or strengthening economy. During these periods, investors are more likely to be confident, investing in higher-yielding bonds as the economy and corporate profits improve. • As the financial health of the issuer improves, demand for its bonds generally increases. This typically results in the value of these bonds rising. • Regular interest payments are also higher, helping offset the negative impact of rising rates on bond values (remember that when interest rates rise, bond values decline). Insulating Portfolios Through Different Interest Rate Environments Areas of the bond market perform differently under changing rate environments Total returns over entire period RISING rate environment FALLING rate environment (%) (%) (%) Government bonds 5.9 -0.3 9.9 Investment grade corporates 6.6 0.4 10.6 High-yield bonds 7.6 6.3 8.4 Emerging market bonds 10.1 11.0 9.6Source: Government bonds: Merrill Lynch’s US Treasury Master Index (GOQO); Investment grade corporates: Merrill Lynch’s US Corporate Master Index (COAO);High-yield bonds: Citigroup’s US High-Yield Market Index; Emerging market bonds: JP Morgan Emerging Market Bond Index (EMBI) Global. Bond return historyJan. 1994 – Jan. 2011. 10
  11. 11. Putting It All TogetherDiversification is not just about building a portfolio; it’s also about maintaining it over time. Due to market movements, portfolioholdings will grow at different rates, and as a result the weightings of each asset class will drift. This drift will ultimately changethe composition of the portfolio and possibly lead to a performance experience that is very different from what the investorwas expecting. A Strong Portfolio Includes Proper Building Blocks and Ongoing Monitoring 5.0 Careful rebalancing can also reduce risk 4.0 Return (%) 3.0 Rebalanced Portfolio 25% Canadian Bonds Buy Hold Portfolio 10% Global High Yield 25% Canadian Bonds 2.0 10% Emerging Market Bonds 10% Global High Yield 20% Canadian Equities 10% Emerging Market Bonds 15% U.S. Equities 20% Canadian Equities 1.0 10% International Equities 15% U.S. Equities 10% Emerging Market Equities 10% International Equities 10% Emerging Market Equities 0 2.9 3.0 3.1 3.2 Risk (Standard Deviation) Source: Morningstar Direct, Risk/Return – Five Years Ended December 2011. Rebalanced annually at calendar year-end.Regular rebalancing is part of a disciplined approach to investing that keeps portfolios on track. Left untouched, asset mix driftcould result in exposure to unexpected risk or missed opportunities. Rebalancing also helps investors buy low and sell high,which over time can reduce volatility and help enhance returns, aiding investors in achieving their long-term objectives.Evolving financial markets, new sources of global economic growth, and technological enhancements have all highlightedwhy investors need to continually review how they diversify their portfolios. The approach to diversification has evolveddramatically over the past 20 years, with new types of securities and investment styles coming to light. Furthermore, investorsnow have the option of diversifying between regions, sectors, asset classes, capitalizations, equity styles and fixed incomeissuers. While taking all of these products and approaches into account adds some complexity to the portfolio managementprocess, there is a significant payoff to doing so as it serves to reduce risk and mitigate volatility levels, ultimately leading to anenhanced investor experience. 11
  12. 12. Economic information has been compiled by RBC Global Asset Management Inc. (RBC GAM) from various sources and is forinformational purposes only. It is not intended to provide legal, accounting, tax, investment, financial or other advice andsuch information should not be relied upon for providing such advice. RBC GAM takes reasonable steps to provide up-to-date,accurate and reliable information, and believes the information to be so when provided. Information obtained from third partiesis believed to be reliable, but no representation or warranty, express or implied, is made by RBC GAM, its affiliates or any otherperson as to its accuracy, completeness or correctness. RBC GAM and its affiliates assume no responsibility for any errors oromissions. Due to the possibility of human and mechanical error as well as other factors, including but not limited to technicalor other inaccuracies or typographical errors or omissions, RBC GAM is not responsible for any errors or omissions containedherein. RBC GAM reserves the right at any time and without notice to change, amend or cease publication of the information.® / ­TM Trademark(s) of Royal Bank of Canada. Used under licence.© RBC Global Asset Management Inc. 2012 40702 (04/2012) 12