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The Evolution of Diversification The World Is Evolving; Portfolios Should Evolve, Too Investors diversify in an effort to mitigate the impact of market fluctuations on their portfolio returns. Over time, this produces a smoother overall investment experience – one that helps strike a balance between growth and safety. The theory of diversification suggests 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 product innovation. In a modern-day context, being effectively diversified has taken on new meaning and a new level of importance given 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 makeup of global capital markets. It is critical that portfolio construction also evolve to reflect this. Diversification today means having exposure to opportunities in fast-growing emerging markets, investing in both large and small companies, incorporating different 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 bonds We 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 Stocks Bonds Diversification 1992 Diversification 2012 Implications for Portfolio Diversification Canada U.S. Europe Japan Geographic Sectors Investment styles Market capitalization Emerging markets Equity portfolios can benefit from more than just a good country mix Government Corporate Federal Provincial Municipal Investment-grade corporate High-yield corporate Emerging markets Convertibles Bond portfolios can benefit from incorporating additional investment options 1. Globalization Free trade between countries, increasing foreign investment, and an increasingly global environment have created greater linkages between countries, particularly in the developed world. Financial innovations now make it easier for investors to access global capital markets but have also increased linkages in risk across different regions. Statistically speaking, the correlation between 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 to the same degree. The opposite is true for markets that are uncorrelated or inversely correlated. This principle of combining investments 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 markets declined sharply following news of Lehman Brothers’ bankruptcy on September 15, 2008. What started out as the bust of the U.S. housing bubble evolved into a financial crisis and emerged as the first simultaneous economic recession in the U.S., Japan and Europe since World War II. For many investors, the financial crisis was a wake-up call that simple diversification across developed regions no longer offered the same benefits of risk mitigation that it had in the past. The convergence of growth patterns over the past 20 years confirms this. Global Economies Now More Linked Than Ever 1.0 0.8 0.6 More Linked 0.4 Less Linked 0.2 Correlation 0.0 -0.2 -0.4 -0.6 Correlation of largest 50 countries’ economic growth vs world GDP -0.8 -1.0 1990 1995 2000 2005 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 this approach alone will not provide the same level of downside protection it may have in the past. This is why adding broader exposure to various geographic regions has become increasingly important. 2 Evolution of Diversification Diversification in 1989... Five years ended December 1989 25 100% International Equities Return (%) 20 dian Equities Old Portfolio: 50% Canadian Equities 25% U.S. Equities 25% International Equities 15 100% U.S. Equities 10 100% Canadian Equities 5 gher Risk 0 6.0 Higher Risk Lower Risk 0.0 1.0 2.0 3.0 4.0 5.0 6.0 Risk (Downside Deviation) Source: Morningstar Direct, Risk/Return – Ten years ended December 1989. ...May Not Be the Best Solution Today 25 25 20 20 15 10 5 0 100% Emerging Markets Equities New Portfolio: 25% Canadian Equities 25% U.S. Equities 25% International Equities 25% Emerging Markets Equities Lower Risk 100% International Equities 0.0 1.0 2.0 100% Canadian Equities Old Portfolio: 50% Canadian Equities 25% U.S. Equities 25% International Equities 100% U.S. Equities 15 Return (%) Return (%) Five Years Ended December 2010 10 5 Higher Risk 3.0 4.0 5.0 0 6.0 0.0 Risk (Downside Deviation) Source: Morningstar Direct, Risk/Return – Ten years ended December 2011. 3 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 2626 2424 Share of World Output (%) 2222 2020 1818 1616 1414 1212 1010 1992 1992 1995 1995 1998 1998 United States United States 2001 2001 Euro Zone Euro Zone 2004 2007 2004 2007 Developing Asia Developing Asia 2010 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 Evolution of Diversification Emerging Markets: The New Economic Powerhouse Fuelled by a strong desire for economic expansion, many emerging markets are increasingly opening their doors to foreign investment. These countries have continued to develop trading relationships with the rest of the world and are in the process of unleashing the economic drive of young, skilled and highly motivated workforces. These countries are playing an increasingly important 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 expected to 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 even register in the Top 10 back in 1987, has since surpassed every European country and now sits in the number 2 spot behind the United States. It’s estimated that by 2030, nearly 16% of the world’s GDP could come from China. Given this progress, it’s no surprise that the economic improvements in emerging markets have led to two decades of rapid growth and strong returns for emerging market equities. An effectively diversified portfolio allows an individual investor to tap into the growth potential of these markets going forward. Emerging Markets Contributing More to Growth Top 10 Economies: Past, Present and Future? Rank 1987 2010 Country % World Economy 1 United States 2 2030* Country % World Economy Country % World Economy 30.1% United States 26.1% United States 22.8% 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? F ree 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. ■ S trong 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. ■L ow debt levels – By and large, governments, consumers and corporations in emerging markets carry much lower levels of debt than their counterparts in developed markets. ■M ore 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 3. Multiple Layers to Equity Investing Individual investors have more choices and opportunities than ever before. Across the spectrum of asset classes and geographic regions, portfolio diversification can be enhanced by looking at small and large companies across different sectors and with very specific characteristics. Investors today have greater access to a far more robust set of opportunities, and these will play an increasingly important role in portfolio performance in the future. Diversifying by Market Capitalization While smaller-cap securities are inherently more volatile than their larger-cap peers, low correlations illustrate a clear benefit to including both in a diversified portfolio. This is mainly due to the fact that over time, small- and large-cap stocks have performed differently. Smaller companies tend to perform well in the early stages of economic recovery, with large caps leading the way as the economic cycle starts to mature. This was the case following the market bottom in March 2009, with large-cap stocks only recently 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 10,000 companies trade on major U.S. exchanges; however, only about 1,000 of the largest are closely followed by analysts and market 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 multiple than one would have to pay to purchase a larger, well-known company of similar quality. Small and Large Companies Will Outperform at Different Times 20.0 Large Companies Have OUTPERFORMED Small Companies 50.3% of the Time Difference in monthly returns (%) (small companies vs. large companies) 15.0 10.0 5.0 0.0 -5.0 -10.0 -15.0 Small Companies Have OUTPERFORMED Large Companies 49.7% of the Time -20.0 1979 1983 1987 Source: Russell Investments. Data as of Jan. 1, 1979 – Dec. 31, 2011 Small companies represented by Russell 2000 TR Index. Large companies represented by Russell 1000 TR Index. 6 Evolution of Diversification 1991 1995 1999 2003 2007 2011 Diversifying by Sector Investors 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 more than 40% of the U.S. market but less than 10% in Canada. Sectors Canada U.S. International Financials 29.4% 13.4% 17.6% Energy 27.1% 12.3% 11.8% Materials 21.1% 3.5% 7.2% Industrials 5.8% 10.7% 11.0% Consumer Discretionary 4.0% 10.7% 10.3% Telecommunications Services 5.2% 3.2% 4.4% Information Technology 1.3% 19.0% 12.0% Consumer Staples 2.8% 11.5% 11.0% Utilities 2.0% 3.9% 4.0% Health Care 1.4% 11.9% 10.5% 77.6% 44.7% 41.5% % Index Weight of Top 3 Sectors ource: Morningstar. Data as of December 31, 2011. Canada represented by S&P/TSX Composite, U.S. represented by S&P 500, S International represented by MSCI World. All in C$. Diversifying by Investment Style Investment style generally refers to the way money is managed and is reflected by the type of securities held in a portfolio. The two styles most commonly referred to are growth and value, and together they provide excellent diversification benefits. Styles Outperform at Different Times Growth ■ G rowth investors generally look for $600 Value stocks have outpaced growth stocks by a wide margin over the past decade. 500 Growth stocks outperformed value stocks through the 1990s. Russell 3000 Growth TR 400 Value Russell 3000 Value TR 300 companies with strong prospects for above-average earnings growth in revenue and earnings. ■ Value ■ V alue investors seek companies trading at prices that don’t reflect their financial strength or future prospects. Value stocks are typically characterized by high dividend yields and strong free cash flow. 200 100 1995 1999 2003 2007 2011 Source: Russell Investments. Investment growth, based on $100 investment in February 1995. Data as of Feb. 27, 1995 – Dec. 30, 2011. Value represented by Russell 3000 Value TR, Growth by Russell 3000 Growth TR. Although an investor may be inclined to rotate from one style to the other depending on market conditions, being invested in both growth and value eliminates the risk of trying to time the market. G rowth stocks tend to perform better during periods of strong economic expansion. ■ B ecause value stocks often have relatively stable earnings, this approach tends to outperform during periods when economic activity is moderating. 7 4. Broader Horizons for Bonds Over the past 20 years, different types of bonds have outperformed as inflation and interest rates fluctuated with changing economic conditions. As with equities, gauging which segment of the bond market will outperform in any given year cannot be reliably predicted. By combining different types of bonds in a portfolio, investors have been able to achieve a meaningful boost in returns with only a marginal increase in volatility. The Many Segments of the Bond Market Historically, government bonds were the primary holding within most fixed income portfolios. That is no longer the case. As interest rates declined over the past 20 years, fixed income investors have continued to seek new solutions that offered higher yields. 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, greater diversification 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 1.7% 2.4% 1.2% 1.3% 2.4% 2.3% 9.6% U.S. High Yield Bonds 5.1% Emerging Markets Bonds 11.5% Canadian Federal Bonds 44.5% U.S. High Yield Bonds 14.4% U.S. High Yield Bonds 10.8% Global Corporate Bonds 8.7% Emerging Markets Bonds 4.9% Global Bonds 9.6% Global Bonds 28.5% Emerging Markets Bonds 12.3% Emerging Markets Bonds 9.7% Canadian Bonds 4.1% Canadian Bonds 4.6% Canadian Federal Bonds 8.6% Canadian Short-term Bonds 18.0% Global Corporate Bonds 9.4% Global Corporate Bonds 8.4% Canadian Federal Bonds 4.0% Canadian Short-term Bonds 4.3% Cash 6.4% Canadian Bonds 5.4% Canadian Bonds 6.7% Canadian Bonds 7.7% Emerging Markets Bonds 3.9% Cash 4.1% Canadian Short-term Bonds 2.6% Cash 4.5% Canadian Short-term Bonds 5.4% Canadian Federal Bonds 6.5% Global Bonds 3.6% Canadian Federal Bonds 3.7% Canadian Bonds -5.8% Global Corporate Bonds 1.1% Global Bonds 3.8% Global Bonds 5.0% U.S. High Yield Bonds 3.2% Global Corporate Bonds 3.7% Global Corporate Bonds -13.9% Emerging Markets Bonds 0.4% Cash 3.6% Canadian Short-term Bonds 4.7% Canadian Short-term Bonds 2.1% Global Bonds 1.5% U.S. High Yield Bonds -25.7% U.S. High Yield Bonds -0.2% Canadian Federal Bonds 0.4% Cash 0.9% Cash Source: RBC Global Asset Management Inc. Data: Jan. 1, 2006 - Dec. 31, 2011. Annual Inflation Bank of Canada Emerging Markets Bonds JP EMBI Global Diversified (CAD Hedged) TR U.S. High Yield Bonds Bank of America Merrill Lynch US High Yield BB-B (CAD Hedged) TR Cash DEX 30-Day Treasury Bill Index (CAD) TR* Canadian Short-term Bonds DEX Short-Term Bond Index (CAD) TR Global Bonds Citigroup World Global Bond Index (CAD Hedged) TR Canadian Bonds DEX Universe Bond Index (CAD) TR Canadian Federal Bonds DEX Universe Federal Bond Index TR Global Corporate Bonds BARCAP US Corporate Investment Grade (CAD Hedged) TR *TR represents total return 8 Evolution of Diversification 2011 High-Yield Bonds Similar to other corporate bonds, a high-yield bond offers a way for investors to lend money to a company in return for regular interest payments and principal at maturity. The “high-yield” label indicates a relatively lower credit quality, which is a measure of financial strength reflected in the ratings issued by agencies such as Moody’s, Standard & Poor’s and Fitch. AAA AA A BBB Lower Risk These agencies assign credit grades on a sliding scale based on their judgment of the issuer’s ability to pay interest and principal as scheduled. As a group, high-yield bonds are typically rated below BBB. Investment Grade BB B CCC CC C Higher Risk High Yield High-yield bonds provide investors with the opportunity for high absolute returns and low correlation with other asset classes over the long term. The high-yield bond market has become an increasingly popular 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 Bonds Emerging 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 in countries 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 on several measures of economic health, including growth rates, financial capacity and overall debt levels. Also, nearly 60% of emerging market government bonds are rated investment-grade by independent rating agencies, meaning that they are of reasonably high quality. Nearly 60% of Emerging Market Bonds Are of Investment-Grade Quality Credit Ratings of Emerging Market Debt 100% 100% 90% 90% 80% 80% 1.3% 1.3% 17.8% 17.8% 6.3 6.3 10.3 10.3 22.0% 22.0% 70% 70% 60% 60% 50% 50% 40% 40% 73.6 73.6 By December 2011, 58.9% of emerging market bonds were investment grade. 30% 30% 20% 20% 10% 10% 0% 0% 1998 1998 9.8% 9.8% 1999 1999 In 1998, 9.8% of emerging market bonds were investment grade. 2000 2000 2001 2001 2002 2002 2003 2003 2004 2004 CCC CCC and and not not rated rated B B 2005 2005 BB BB 2006 2006 2007 2007 2008 2008 2009 2009 2010 2010 58.9% 58.9% 2011 2011 BBB BBB and and higher higher Source: J.P. Morgan, EMBI Global Index Credit Composition. Data as of Dec. 31, 1998 – Dec. 31, 2011. 9 Why a Mix of Different Bonds Works 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. Over time, the performance of different bonds reflects the risk assumed by investors – that’s why government bond returns typically lag corporate, highyield and emerging market debt. But in terms of diversification, the benefit of holding various fixed income securities becomes clear when investors assess performance across the interest rate cycle. During periods when interest rates are rising, high-yield and emerging market debt tends to perform well compared to government bonds. There are several reasons 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 FALLING rate environment (%) environment (%) Government bonds 6.1 -0.3 10.0 Investment grade corporates 6.6 0.4 10.3 High-yield bonds 7.4 6.3 8.0 Emerging market bonds 10.1 11.0 9.6 Source: 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 history Jan. 1994 – Dec. 2011 10 Evolution of Diversification Putting It All Together Diversification is not just about building a portfolio; it’s also about maintaining it over time. Due to market movements, portfolio holdings will grow at different rates, and as a result the weightings of each asset class will drift. This drift will ultimately change the composition of the portfolio and possibly lead to a performance experience that is very different from what the investor was expecting. A Strong Portfolio Includes Proper Building Blocks and Ongoing Monitoring 5.0 Careful Rebalancing can also Reduce Risk Return (%) 4.0 3.0 Rebalanced Portfolio 25% Canadian Bonds 10% Global High Yield 10% Emerging Market Bonds 20% Canadian Equities 15% U.S. Equities 10% International Equities 10% Emerging Market Equities 2.0 1.0 0 2.9 3.0 Buy & Hold Portfolio 25% Canadian Bonds 10% Global High Yield 10% Emerging Market Bonds 20% Canadian Equities 15% U.S. Equities 10% International Equities 10% Emerging Market Equities 3.1 3.2 Risk (Downside 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 drift could 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 highlighted why investors need to continually review how they diversify their portfolios. The approach to diversification has evolved dramatically over the past 20 years, with new types of securities and investment styles coming to light. Furthermore, investors now have the option of diversifying between regions, sectors, asset classes, capitalizations, equity styles and fixed income issuers. While taking all of these products and approaches into account adds some complexity to the portfolio management process, there is a significant payoff to doing so as it serves to reduce risk and mitigate volatility levels, ultimately leading to an enhanced investor experience. 11 Economic information has been compiled by RBC Global Asset Management Inc. (RBC GAM) from various sources and is for informational purposes only. It is not intended to provide legal, accounting, tax, investment, financial or other advice and such 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 parties is believed to be reliable, but no representation or warranty, express or implied, is made by RBC GAM, its affiliates or any other person as to its accuracy, completeness or correctness. RBC GAM and its affiliates assume no responsibility for any errors or omissions. Due to the possibility of human and mechanical error as well as other factors, including but not limited to technical or other inaccuracies or typographical errors or omissions, RBC GAM is not responsible for any errors or omissions contained herein. 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 (08/2012)