08 October 2010 VOLUME 603

Modern Portfolio Theory – The impact of Diversification & Correlation

WRITTEN BY: Ian Brink, Glacier Research

Diversification is the corner stone of modern portfolio theory, yet despite being familiar with the term, few investment professionals fully understand the
mechanics underlying this phenomenon. The principle of diversification is best explained by drawing on the conventional wisdom of the old adage of
not “placing all one’s eggs in a single basket”, but over and above the mere message of spreading one’s risk, which the adage attempts to convey,
there is also a real statistical benefit derived from portfolio diversification.

To explain the benefits of diversification, let’s assume that we have a portfolio of different stocks. These stocks are from different sectors, different
industries, have different management teams, some are defensive, some are cyclical, and they have differing sensitivities to interest rates, consumer
demand, and other market influences. If something in the greater economy (or market) changes, the effects on the various stocks will be different -
some stocks might increase in value as a result of the change and others will decrease in value. Moreover, those that increase (or decrease) in value
will do so by differing degrees. The point is that by holding different stocks, the reaction to an exogenous influence will cause some stocks to go up and
some to go down, and assuming we hold sufficient stocks, and more importantly, sufficiently different stocks, the increases in some stock prices will
cancel out the decreases in other stock prices. The risk that the unique characteristics of a particular stock will cause it to decline in value in response
to an exogenous influence is referred to as its unique or unsystematic risk. An example of an unsystematic risk might be a strike by motor vehicle
manufacturing workers, which would presumably negatively impact only those industries associated with the motor vehicle industry. The same principle
might be applied to any type of portfolio of financial assets such as a unit trust portfolio.

Sometimes an exogenous influence might cause a market wide increase or decrease in stock prices irrespective of the unique characteristics of
individual stocks. The risk that an exogenous influence will cause a market wide decline in value is referred to as systematic risk or market risk.
Irrespective of how many stocks we hold in our portfolio or how different they are, there will be no cancellation of the market movement as a result of
this type of influence, since all the stocks (or unit trusts) are influenced to the same degree. An example of such an influence might be a decline in
GDP, which causes all equities (or unit trusts) to be adversely affected. Another example might be a catastrophic political event such as the September
11 terrorist attacks which causes a market wide decline in equities.

Before we are able to explain the mechanics of diversification, we need to first of all understand what “risk” is in the context of investment theory. Risk
is essentially defined as the unpredictability of returns from an investment. This definition of risk is usually quantified by a measure referred to as
standard deviation. The use of standard deviation as a measure of dispersion implicitly assumes that the returns derived from an investment are
normally distributed with most of the returns occurring close to the mean and with the frequency of returns falling off exponentially as one moves away
from the mean. That said, standard deviation is thus a measure of the dispersion of returns from the mean or expected return. This risk, as we saw
previously, may be split up into unsystematic risk and systematic risk. More importantly the unsystematic risk can be diversified away (by holding
sufficient stocks and sufficiently different stocks), whereas the systematic risk or market risk cannot be diversified away.

Many investors know and understand that there is an intrinsic relationship between risk and expected return. The more risk an investor is willing to
bear, the greater the potential reward for bearing this risk. What few investors realize however, is that the relationship is not between total risk
(systematic plus unsystematic risk) and the expected return, but rather between systematic risk and expected return. What this boils down to, is that
investors are only rewarded for the risk which cannot be diversified away i.e. investors are only rewarded for bearing systematic (or market) risk. Since
unsystematic risk may be diversified away at no cost (theoretically at least) there is no reward earned for bearing it.

Tel +27 21 917 9002 / 0860 GLA ENG Glacier Financial Solutions (Pty) Ltd, A member of the Sanlam Group
Private Bag X5 Tyger Valley 7536 Fax +27 21 947 9210 Reg No 1999/025360/07 Licensed Financial Services Provider
email client.services@glacier.co.za Web www.glacier.co.za Directors AA Raath (Chairman and Chief Executive), A Banderker, MT Möller

The information contained in this document has been recorded and arrived at by Glacier Financial Solutions (Pty) Ltd in good faith and from sources believed to be reliable, but no representation or warranty, expressed or
implied, is made as to its accuracy, completeness or correctness. The information is provided for information purposes only and to assist the financial intermediary to submit an investment proposal to the client and
should not be construed as the rendering of investment advice to clients. Glacier Financial Solutions (Pty) Ltd accordingly accepts no liability whatsoever for any direct, indirect or consequential loss arising from the use
or reliance, in any manner, of the information provided in this document.
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Diversification should thus not be seen as an enhancement to a portfolio, but rather fundamental to constructing portfolios which maximize return for a
particular level of risk or conversely minimize risk for a particular level of return. The level of diversification in a portfolio is dependent on how differently
the assets (stocks or funds) in that portfolio move relative to each other.

The significant impact of diversification can be seen in the rather daunting equation below. This equation is used to calculate the portfolio risk of a two
asset portfolio.

σp2=wa2σa2 + wb2σb2 + 2wawbσaσbρab

where

portfolio risk = standard deviation = σp

σa and σb are the standard deviations (risk) of fund a and b respectively
wa and wb are the weightings of funds a and b in the portfolio respectively
ρab is the correlation of fund a with fund b
There is no need to commit this equation to memory, rather there are two important points to take into consideration here. Firstly, portfolio risk σp is
not merely an arithmetic average of the risks of the individual funds ( σa and σb). Secondly, the portfolio risk σp is a function of the correlation
between the two funds ρab in this case fund a and b. Note that this theory applies equally to funds as they do to stocks or any financial assets for
that matter which is why I have used funds and stocks interchangeably.

Correlation refers to the degree to which one asset’s returns move relative to another’s. It’s important to understand that this correlation is a statistical
measure. Frequently, individuals associate correlation with the asset composition of the funds in question. Yet despite the fact that asset composition
plays an important role in the behavior of funds and ultimately in the performance which they deliver, asset composition is but only one factor which
influences the returns delivered by a fund. Ultimately, the correlation (in the strictest statistical sense) is a measure of how fund returns move relative to
each other. The importance of calculating correlation thus becomes apparent. However since correlation is a standard statistical measure, it may be
quite easily calculated using a standard spreadsheet application such MS Excel. The example below illustrates using Excel’s “correl” formula on 3
arrays of data corresponding to the AG Equity Fund, SIM General Equity Fund and the SIM Active Income Fund for the period from the beginning of
2010 till the beginning of October 2010:

SIM SIM
Monthly General Active
Performance AG Equity Equity Income
01/02/2010 -1.72% -3.14% 0.60%
01/03/2010 1.68% 2.21% 1.05%
01/04/2010 3.83% 7.42% 1.32%
01/05/2010 0.91% -0.18% 0.64%
01/06/2010 -3.59% -5.48% 0.39%
01/07/2010 0.31% -1.00% 0.79%
01/08/2010 4.52% 6.24% 1.34%
01/09/2010 0.34% -1.15% 1.26%
01/10/2010 4.36% 5.91% 0.61%

Tel +27 21 917 9002 Glacier Financial Solutions (Pty) Ltd, A member of the Sanlam Group
Private Bag X5 Tyger Valley 7536 Fax +27 21 947 9210 Reg No 1999/025360/07 Licensed Financial Services Provider
email client.services@glacier.co.za Web www.glacier.co.za Directors AA Raath (Chairman and Chief Executive), A Banderker, MT Möller

The information contained in this document has been recorded and arrived at by Glacier Financial Solutions (Pty) Ltd in good faith and from sources believed to be reliable, but no representation or warranty, expressed or
implied, is made as to its accuracy, completeness or correctness. The information is provided for information purposes only and to assist the financial intermediary to submit an investment proposal to the client and
should not be construed as the rendering of investment advice to clients. Glacier Financial Solutions (Pty) Ltd accordingly accepts no liability whatsoever for any direct, indirect or consequential loss arising from the use
or reliance, in any manner, of the information provided in this document.
 FUNDS ON FRIDAY | 03

The correlation between the two equity funds is 98%, whilst the correlation between AG Equity and SIM Active Income is 62%. As expected the two
equity funds have a higher correlation due to their similar asset compositions, whereas the AG Equity fund and the SIM Active Income fund has a lower
correlation. The point is that even though asset composition has a major effect on the correlation of two funds, the correlation itself is measured on the
returns of the funds relative to each other. This is because it is ultimately the returns of the funds which contain the effects of the asset compositions, as
well as the numerous other factors which influence the changes in the fund returns.

The previous demonstration made use of monthly data in order to illustrate the methodology for calculating correlation. In practice, one would use the
frequency of data with the highest resolution, which in this case is daily data. This would lead to a much more accurate correlation measure, since
monthly data aggregates away a lot of the intra-monthly movement in the returns. Using daily data the correlation between the 2 equity funds over the
same period of time is 90% whilst the correlation between the AG Equity Fund and the SIM Active Income fund is 32%.

The Glacier Toolbox essentially attempts to take the number crunching exercise out of the portfolio construction process, and uses the same theory
discussed herein to derive portfolio risk. Where the Toolbox departs from classical modern portfolio theory, is that instead of merely defining risk as
variation in returns from the mean (read standard deviation) we have also added in the effects of downside deviation into our calculation of risk.
Downside deviation enhances our risk measure by explicitly adding in the downside risks associated with volatility. The Glacier Toolbox calculates fund
correlations using 3 years’ worth of daily returns.

Tel +27 21 917 9002 Glacier Financial Solutions (Pty) Ltd, A member of the Sanlam Group
Private Bag X5 Tyger Valley 7536 Fax +27 21 947 9210 Reg No 1999/025360/07 Licensed Financial Services Provider
email client.services@glacier.co.za Web www.glacier.co.za Directors AA Raath (Chairman and Chief Executive), A Banderker, MT Möller

The information contained in this document has been recorded and arrived at by Glacier Financial Solutions (Pty) Ltd in good faith and from sources believed to be reliable, but no representation or warranty, expressed or
implied, is made as to its accuracy, completeness or correctness. The information is provided for information purposes only and to assist the financial intermediary to submit an investment proposal to the client and
should not be construed as the rendering of investment advice to clients. Glacier Financial Solutions (Pty) Ltd accordingly accepts no liability whatsoever for any direct, indirect or consequential loss arising from the use
or reliance, in any manner, of the information provided in this document.