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The benefits and pitfalls of foreign diversification

17 November 2009 Chris du Toit , Allan Gray

Most South African investors looking to diversify will choose to include offshore assets in their portfolio, particularly now that exchange controls have been further relaxed. The trick is to select the right combination of foreign assets and asset managers in order to achieve diversification without sacrificing long-term performance, says Chris du Toit, an analyst at Allan Gray, which invests offshore through Orbis.

Shares of companies that operate in different industries and different parts of the world should behave differently. Business and economic cycles favour different companies at any given point in time, and therefore investing in those different companies should yield different (unrelated) returns over time.

“A diversified portfolio of assets should produce returns at lower levels of volatility over the long term,” says du Toit.

The concepts of correlation and volatility are central to portfolio diversification. Correlation measures the strength of the relationship between two assets’ returns. A positive correlation indicates a strong positive relationship, i.e. the two assets tend to have higher and lower returns at the same time. For example, the returns of South African shares are highly correlated with emerging markets. This is partly due to the behaviour of global investors who treat all emerging markets as a single asset class.

A negative correlation implies the opposite, i.e. the two assets’ returns move in opposite directions at any given time. A correlation of zero implies that no relationship (positive or negative) exists between the returns of the two assets.

A portfolio consisting of assets that are all positively correlated with each other is not diversified. “An undiversified portfolio is not a problem if all the assets are performing well, but it is a problem if all the assets are performing poorly.”

By adding assets with zero, or negative correlation, a portfolio becomes more diversified. “The effectiveness of diversification can be measured by the extent to which the portfolio’s overall volatility, or deviation of its returns, is reduced, without sacrificing performance along the way,” du Toit concludes.

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