Aon Hewitt
Retirement Solutions
Investment
Insights
February 2015
Global Investment Consulting
In this issue
Diversification–What’s in the toolbox?
Diversification–What’s
in the toolbox?
Summary
1
Summary

2
What is diversification and
why is it important?
Although equities and bonds are expected to form the cornerstone of institutional portfolios,
their roles in modern portfolios are increasingly diminished as projected risk/return profiles
for these asset classes have deteriorated.
3
What’s in the toolbox?

4
References
As we continue to anticipate more difficult return environments, there are a number of other,
useful and readily accessible tools on the shelf today that are made available to smaller
institutional investors.

With the evolution of non-traditional asset classes coupled with the emergence of Diversified
Growth Funds1 and managed/delegated consulting solutions, these tools are accessible
to plan sponsors of all sizes and types.

Understanding the range of available diversification tools is important for the governance
and prudent management of your plan’s investments.
Risk. Reinsurance. Human Resources.
What is diversification and why is it important?
Investors who hold all of their growth assets in a single asset class, such
as equities, are exposed to the risk of unmanageable short-term losses.
Diversification involves investing in a range of asset classes to provide
protection as, at any one time, it is likely that some asset classes will be
rising as others are falling. For most investors, introducing additional
diversification remains as the lowest hanging fruit for improving
a fund’s risk/return profile. For those investors that only have exposure
to portfolios of stocks and bonds, introducing additional asset classes
will provide significant added benefits.
Consider the performance of four hypothetical portfolios: an all-cash
portfolio; an all-stock portfolio; a balanced portfolio of 60% stocks and
40% bonds; and a balanced plus portfolio of 45% stocks, 35% bonds,
10% real estate, and 10% diversified growth funds 1
1
Compared to traditional balanced funds, some Diversified Growth Funds (DGFs) take
a more dynamic approach to choosing how much to invest in different asset classes,
and how much to invest in the underlying securities within each asset class. They aim
to build a very diversified portfolio that also includes non-traditional asset classes,
tilting their portfolios to areas of the market that they believe will perform best.
Many different asset classes simultaneously lost value exhibiting
increased correlations during the 2008 financial crisis. Despite the high
correlation of major asset classes demonstrating negative returns,
diversification still proved beneficial to portfolios by limiting the losses.
Diversification Benefits
All-cash
All-stock
Balanced
Balanced Plus
Cumulative Performance
50.0%
40.0%
30.0%
20.0%
10.0%
0.0%
-10.0%
-20.0%
-30.0%
Jan-14
May-14
Sep-13
Jan-13
May-13
Sep-12
Jan-12
May-12
Sep-11
Jan-11
May-11
Sep-10
Jan-10
May-10
Sep-09
Jan-09
May-09
Sep-08
Jan-08
May-08
-40.0%
All-cash
All-stock
Balanced
Balanced Plus
Cumulative Performance (%)
Decline:
Recovery:
Jan-2008
Mar-2009
to
to
Feb-2009
Sept-2014
2.7
4.1
-38.0
123.0
-22.7
83.4
-18.0
77.8
Standard Deviation
(%)
Jan-2008
to
Sept-2014
Jan-2008
to
Sept-2014
7.0
38.2
41.9
45.9
0.4
15.2
8.8
7.2
Source: The balanced portfolio is illustrated using 30% S&P/TSX Composite, 30% MSCI World excl. Canada (Net) (CAD) and 40% FTSE TMX Universe Bond. The balanced plus portfolio is illustrated
using 22.5% S&P/TSX Composite, 22.5% MSCI World excl. Canada (Net) (CAD), 35% FTSE TMX Universe Bond, 10% Investment Property Databank and 10% median Diversified Growth Fund.
The all-stock portfolio is illustrated using 50% S&P/TSX Composite and 50% MSCI World excl. Canada (Net) (CAD). The All-cash portfolio is illustrated by the FTSE TMX 30-Day T-Bill Index.
During the 14 month bear market (Jan-2008 to Feb-2009), the all-stock
portfolio lost over a third of its initial value (-38.0%); however,
the balanced and balanced plus portfolios lost significantly less
(-22.7% and -18.0%, respectively). The diversification of the balanced
portfolios didn’t prevent losses, but rather dampened them.
The all-cash portfolio (2.7%) outperformed the all-stock and both
balanced portfolios over this period. Transitioning to an all-cash
portfolio might have seemed like a good place to seek cover in early
2009, but after March 2009, the all-cash portfolio increased by 4.1%,
significantly lower than the 123.0% increase from the all-stock portfolio,
the balanced portfolio increase of 83.4% and the balanced plus
portfolio increase of 77.8% as equity markets rebounded the most.
Risk, as measured by standard deviation, was significantly higher
for the all-stock portfolio (15.2%) relative to the balanced and
balanced plus portfolios (8.8% and 7.2%, respectively).
While the diversified balanced and balanced plus portfolios did not
produce the highest returns in rising markets, they also captured less
of the downside, essentially delivering superior risk-adjusted returns
over the long-term, compared to just investing in stocks. This is why
diversification is important.
Another key observation is that by further diversifying the balanced
portfolio by adding some more commonly used alternative asset
classes, the balanced plus portfolio yielded even greater risk-adjusted
returns (higher return and lower volatility).
Over a longer cycle, from January 2008 to September 2014, the balanced
portfolio displayed similar cumulative returns to that of the all-stock
portfolio (41.9% versus 38.2%, respectively). While the end-result was
similar, the road to get there was very different. The all-stock portfolio
exhibited much greater volatility of returns, exemplified by larger
declines and increases.
Investment Insights | Aon Hewitt | February 2015
2
What’s in the toolbox?
Equities as an asset class can be expanded to include foreign, small cap,
developed, emerging, public and private equities. It can also be
managed differently: active and passive, long-only and long-short.
Fixed income can be subdivided into risk-reducing (volatility-dampening
and liability-hedging bonds) and return-seeking (high yield, core plus
and multi-asset credit portfolios).
Although traditional asset classes, such as long-only equities and fixed
income provide a good base, the typical domestically biased 60/40
equity/fixed income portfolio is limited in its ability to meet the necessary
return objectives for pension plans. At the same time, the investment
options that have been made available to smaller institutional investors
provide more tools at investors’ disposal. Aon Hewitt’s 2013 Global
Pension Risk Survey noted a trend of organizations diversifying out
of equities and into other asset classes. Over 30% of plans surveyed
have already increased or are planning to increase their allocations
to alternatives, and we expect that results from our 2014 survey will
demonstrate a similar trend.
Other more commonly used specialized tools include strategies such as
real estate, infrastructure and absolute return.
There are two avenues for investors to introduce greater diversification
into their fund structures. One is to diversify within existing asset classes
and the other is to introduce new, opportunistic asset classes.
The following table illustrates our correlation assumptions between
various asset classes. Correlations can range between +1, indicating
a strong positive relationship, and -1, indicating a strong negative
or inverse relationship. A correlation of zero or near zero indicates
that there is not a strong relationship between the asset classes.
0.6
1.0
(0.2)
0.2
0.1
0.1
1.0
Infrastructure (Direct)
(0.2)
0.3
0.1
0.1
0.3
1.0
Private Equity
Private Equity
(0.0)
0.7
0.7
0.6
0.3
0.3
1.0
Absolute Return Strategies
0.3
0.4
0.3
0.3
0.1
0.1
0.4
1.0
Universe Bonds
1.0
Canadian
Equities
Canadian Equities
0.1
1.0
Global Equities
Global Equities
0.1
0.7
1.0
Emerging Markets
Emerging Markets
Absolute Return Strategies
As depicted in the table above, traditional asset classes exhibit greater
correlation with one another than with other more specialized tools.
Investing in uncorrelated asset classes can reduce the volatility
of your portfolio’s overall returns.
Infrastructure (Direct)
0.6
Canadian Real Estate
(Direct)
Universe
Bonds
0.1
Canadian Real Estate (Direct)
Correlations
References

Aon Hewitt, A Holistic Approach to Equity Investing

Aon Hewitt 2013 Global Pension Risk Survey
Historically, non-traditional asset classes were often perceived as being
available to only the largest of institutional investors. However,
with the evolution of these asset classes coupled with the emergence
of Diversified Growth Funds and managed/delegated consulting
solutions, these tools are accessible to plan sponsors of all sizes
and types.
Understanding the range of available diversification tools should be
a key objective. Your Aon Hewitt representative will work with you
throughout the year to look into the toolbox and develop
a diversification enhancement strategy that is appropriate
for your investment program.
Investment Insights | Aon Hewitt | February 2015
3
Contact Information
If you would like further information on any of these topics, please contact your Aon Hewitt consultant at [email protected].
Aon Hewitt publishes Investment Insights for the purposes of providing general information. The information in Investment Insights does not constitute
financial, legal, or any specific advice and should not be used as a basis for formulating business decisions. For information tailored to your organization’s
specific needs, please contact your consultant at Aon Hewitt. This issue of Investment Insights contains information that is proprietary to Aon Hewitt
and may not be distributed, reproduced, copied or amended without Aon Hewitt’s prior written consent.
About Aon Hewitt
Aon Hewitt empowers organizations and individuals to secure a better future through innovative talent, retirement and health solutions. We advise, design and
execute a wide range of solutions that enable clients to cultivate talent to drive organizational and personal performance and growth, navigate retirement risk
while providing new levels of financial security, and redefine health solutions for greater choice, affordability and wellness. Aon Hewitt is the global leader
in human resource solutions, with over 30,000 professionals in 90 countries serving more than 20,000 clients worldwide. For more information on Aon Hewitt,
please visit aonhewitt.com.
© 2015 Aon Hewitt Inc. All Rights Reserved.
This document contains confidential information and trade secrets protected by copyrights owned by Aon Hewitt. The document is intended to remain strictly confidential and to be used only for your internal needs
and only for the purpose for which it was initially created by Aon Hewitt. No part of this document may be disclosed to any third party or reproduced by any means without the prior written consent of Aon Hewitt.
Risk. Reinsurance. Human Resources.