QS Investors Diversification Based Investing Whitepaper - FTSE

To further illustrate how good and bad diversifiers are
weighted in the portfolio, figure 9 shows how Netherlands
Financial Services (1 of 31 risk units in Cluster 1) and
Japanese Utilities (1 of 4 risk units in Cluster 2) are
correlated to all other risk units. Netherlands Financial
Services shows relatively high correlations to almost all other
risk units and is therefore not a good diversifier. Intuitively
this means that there are many risk units that have a
Correlation
100%
80%
60%
40%
20%
0%
-20%
-40%
Step 4 | Implementation
The objective of this step is to capture structural changes
between countries and industries, while controlling turnover
to keep transaction and market impact costs low. The
clustering process occurs annually when the largest part of
the relevant FTSE benchmark reconstitutes. For example, the
FTSE DBI Developed Index reclustering is completed in
December to coincide with the constituent review
FTSE DBI Page 11
Risk Units
common risk exposure (cyclical/financial services). As a
consequence, it is grouped in a Cluster with many risk units
and gets a small total portfolio weight (0.36%). In contrast,
Japanese Utilities is highly correlated to only a few other risk
units and is negatively correlated with over half of the other
risk units. Because of this, it is a good diversifier; it is
therefore grouped in a cluster with fewer risk units and is
allocated a higher weight (2.78%) as a consequence.
Figure 9: Overweighting good diversifiers; correlation pair example – two risk units to every other risk unit
Japan Utilities
(1 of 4 Risk Units in Cluster)
Netherlands Financial Services
(1 of 31 Risk Units in Cluster)
1
4
7
10
13
16
19
22
25
28
31
34
37
40
43
46
49
52
55
58
61
64
67
70
73
76
79
82
85
88
91
94
97
100
103
106
109
112
115
118
121
As of September 30th, 2010.
Source: QS Investors LLC. For illustration purposes only
High Correlation
Bad Diversifiers
Low Correlation
Good Diversifiers
(reconstitution) that occurs in that index for North America.
As constituent names will change in December, DBI changes
clusters / risk unit weights / stock specific weights to coincide
with that turnover. Immediately after that, market drift
occurs. To maintain diversification, the DBI Indexes are
rebalanced back to the original diversification weights once a
quarter. This process is illustrated below in Figure 10.
Figure 10: Implementation – Example of Clustering and Rebalancing timeline for FTSE DBI Developed Index
Cluster
Rebalance Rebalance Rebalance
Cluster
December March June September December