the evolution of diversification

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.

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Diversification1992

Diversification2012

Implications for Portfolio Diversification

Stocks

CanadaU.S.

EuropeJapan

GeographicSectors

Investment stylesMarket capitalization

Emerging markets

Equity portfolios can benefit from more than just a good country mix

BondsGovernment

Corporate

Federal ProvincialMunicipal

Investment-grade corporate

High-yield corporateEmerging markets

Convertibles

Bond portfolios can benefit from incorporating additional investment options

20 Years Later, Opportunities for Investors to Diversify are Significantly Different

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.

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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.

Global economies now More linked Than ever

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-0.6

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2007

2008

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2010

Correlation of Largest 50 Countries

Economic Growth vs World GDP

(10-year rolling)

Correlation of largest 50 countries’ economic growth vs world GDP

Source: World Bank, 10-Year Rolling Returns.

More Linked

Less Linked

Corr

elat

ion

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Diversification in 1989...

...May not Be the Best solution Today

Retu

rn (%

)

Risk (Standard Deviation)

Five Years Ended December 2010 Five years ended December 1989

25

20

15

10

5

0

New Portfolio:

25% Canadian Equities

25% U.S. Equities

25% International Equities

25% Emerging Markets Equities

Old Portfolio:


25% U.S. Equities




Lower Risk Higher Risk

100% U.S. Equities


100% U.S. Equities



Old Portfolio:


25% U.S. Equities


0.0 1.0 2.0 3.0 4.0 5.0 6.0

Retu

rn (%

)


25

20

15

10

5

0 Lower Risk Higher Risk

0.0 1.0 2.0 3.0 4.0 5.0 6.0

Source: Morningstar Direct, Risk/Return – Ten years ended December 1989.

Source: Morningstar Direct, Risk/Return – Ten years ended December 2011.

Retu

rn (%

)


Five Years Ended December 2010 Five years ended December 1989

25

20

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10

5

0

New Portfolio:


25% U.S. Equities



Old Portfolio:


25% U.S. Equities




Lower Risk Higher Risk

100% U.S. Equities


100% U.S. Equities



Old Portfolio:


25% U.S. Equities


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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.

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101992 1995 1998 2001 2004 2007 2010

United States

Euro Zone

Developing Asia

Source: IMF World Economic Outlook, PPP Basis.

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utpu

t (%

)

Developing asia contributing More to Global Production

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.

emerging Markets: The new economic PowerhouseFuelled 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 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 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.

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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.

emerging Markets contributing More to Growth

Source: World Bank, USDA. *Projected. Measured by GDP.

Rank 1987 2010 2030*

Country% World 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%

Top 10 economies: Past, Present and future?

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 capitalizationWhile 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.

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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.

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1983 1987 1991 1995 1999 2003 2007 2011

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small and large companies Will outperform at Different Times

Large Companies OUTPERFORM Small Companies

Small Companies OUTPERFORM Large Companies

over the past 30 years, large companies have outperformed small companies on a monthly basis 50.3% of the time.

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 than 10% in Canada.

Sectors Canada U.S. InternationalFinancials 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 S&P/TSX Composite, U.S. represented by S&P 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. The two styles most commonly referred to are growth and value, and together they provide excellent diversification benefits.

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Growth• Growth investors generally look for

companies with strong prospects for above-average earnings growth in revenue and earnings.

• Growth stocks tend to perform better during periods of strong economic expansion.

value• Value 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.

• Because value stocks often have relatively stable earnings, this approach tends to outperform during periods when economic activity is moderating.

Valu

e

Growth stocks far outperformed value stocks through the 1990s technology-driven market.

However, value has outpaced growth by a wide margin over the past decade.

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Russell 3000 Value TR

Russell 3000 Growth TR

1995 1998 2001 2004 2007 2010

styles outperform at Different Times

Source: Russell Investments. Investment growth, based on $100 investment in February 1995. Data as of Feb. 27, 1995 – Dec. 30, 2011.

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.

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 MarketHistorically, 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.

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A Mix of Different Bonds Can Provide a Better Investment Experience

2006 2007 2008 2009 2010 20111.7% 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

Annual Inflation Bank of CanadaEmerging 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

CashDEX 30-Day Treasury Bill Index (CAD) TR*

Canadian Short-term Bonds

DEX Short-Term Bond Index (CAD) TR

Global BondsCitigroup World Global Bond Index (CAD Hedged) TR

Canadian BondsDEX 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

Source: RBC Global Asset Management Inc. Data: Jan. 1, 2006 - Dec. 31, 2011.

*TR represents total return

returns on Different fixed income investments: 2006 – 2011

high-Yield BondsSimilar 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.

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.

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 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 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, more than 50% of emerging market government bonds are rated investment-grade by independent rating agencies, meaning that they are of reasonably high quality.

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100%

90%

80%

70%

60%

50%

40%

30%

20%

10%

0%

1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011

6.3%

10.3%

73.6%

9.8%

56.4%

33.9%

8.9%

0.8%

over 50% of emerging Market Bonds are of investment-Grade Quality

Source: J.P. Morgan, EMBI Global Index Credit Composition. Data as of Dec. 31, 1998 – June 30, 2011.

in 1998, 9.8% of emerging market bonds were investment grade.

By June 2011, 56.4% of emerging market bonds were investment grade.

CCC and not rated

B

BB

BBB and higher

credit ratings of emerging Market Debt

AAAAAABBB

BBBCCCCCC

High Yield

Lower Risk

Higher Risk

InvestmentGrade

Why a Mix of Different Bonds WorksOver time, the performance of different bonds reflects the risk assumed by investors – that’s why government bond returns typically lag corporate, high-yield 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).

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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.

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 9.6

insulating Portfolios Through Different interest rate environments

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 – Jan. 2011.

areas of the bond market perform differently under changing rate environments

Putting it all TogetherDiversification 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.

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Retu

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5.0

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Buy & Hold Portfolio25% Canadian Bonds10% Global High Yield10% Emerging Market Bonds20% Canadian Equities15% U.S. Equities10% International Equities10% Emerging Market Equities

Rebalanced Portfolio25% Canadian Bonds10% Global High Yield10% Emerging Market Bonds20% Canadian Equities15% U.S. Equities10% International Equities10% Emerging Market Equities

2.9 3.0 3.1 3.2

a strong Portfolio includes Proper Building Blocks and ongoing Monitoring

Source: Morningstar Direct, Risk/Return – Five Years Ended December 2011. Rebalanced annually at calendar year-end.

Careful rebalancing can also reduce risk

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.

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 (04/2012)

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the evolution of diversification

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