Most South African investors looking to diversify will choose to include offshore assets in their portfolio. The trick is to select the right combination of foreign assets and asset managers in order to produce the desired result — in other words, diversification without sacrificing long-term performance. The concepts of volatility and correlation play a central role in understanding the benefits and pitfalls of diversifying by investing offshore. Chris du Toit of Allan Gray explains…

South Africa is a relatively small, open economy. Our stock market consists of some 370 companies and makes up just over one percent of the world’s total listed equity universe by market capitalisation. For South African investors, offshore assets are a natural option when looking to build a diversified portfolio.

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.

Correlation and volatility

According to the text books, a diversified portfolio of assets should produce returns at lower levels of volatility over the long term. 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. 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. We measure the effectiveness of diversification by the extent to which the portfolio’s overall volatility, or deviation of its returns, is reduced. Intuitively, a portfolio consisting of correlated assets will show larger deviations in its overall returns (a high volatility), and a portfolio consisting of uncorrelated assets should show smaller deviations in its overall returns.

How different are the assets you invest in?

As indicated in previous commentary, the returns of South African shares are highly correlated with broader emerging markets, partly due to the behaviour of global investors who treat all emerging markets as a single asset class.

Because emerging markets and equities are highly correlated to the ALSI, adding the two together produces a portfolio with higher volatility than the ALSI. This illustrates the importance of investing in uncorrelated foreign assets if and when you are looking to diversify your overall portfolio.

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