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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
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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,
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© RBC Global Asset Management Inc. 2012
40702 (08/2012)