Diversification is an important topic for many investors as it plays a crucial role in managing risk. This month we detail how diversification is measured and how it can help portfolios over the long term by lowering correlations.

1. Market Perspectives – December 2015
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Overview: Diversification is a frequently discussed investing tool and is often misused in the
context of reducing volatility. Limiting exposure to any one particular asset class or investment
type will help reduce volatility when correlations are monitored carefully. During periods of high
market volatility, correlations often increase. Many stocks in a wide variety of sectors tend to
move together when investors need diversification most. This month we go into more detail
about how we view diversification, how to lower portfolio correlations, and how diversification
can help a portfolio over the long-term.

2. Risk Defined – Made of Both Aggregate and Specific Factors
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• Systematic Risk is vulnerability to events that affect aggregate market
returns. Examples include government policy, international economic
forces, or acts of nature.
• Idiosyncratic Risk, in contrast, is risk to which only specific companies
or industries are vulnerable. This is sometimes called specific risk and
is uncorrelated with broad market returns. This risk can be mitigated
by purchasing many different stocks.
• During periods of high market volatility, systematic risk will increase
dramatically, while idiosyncratic risk will not rise as much. This will lead
to higher correlations, as systematic risk increases and becomes a
larger proportion of the total risk equation.
• During bear markets, many stocks will tend to correlate as systematic
risk becomes the overriding focus of investors.
• For example, the table to the right shows the correlations of 6
unrelated equity sector ETFs to the S&P 500 during the 2008 market
decline. Notice all statistics are highly correlated.
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Security Correlation to S&P 500
SPDR S&P 500 ETF TRUST 1.00
SPDR MORGAN STANLEY TECHNOLO 0.91
SPDR S&P BIOTECH ETF 0.87
SPDR OIL & GAS EQUIP & SERV 0.86
SPDR S&P BANK ETF 0.80
SPDR S&P RETAIL ETF 0.79
SPDR S&P SEMICONDUCTOR ETF 0.74
Source: Bloomberg
Correlation of Sector ETFs to S&P 500
from 8/1/2008 to 12/31/2008

3. Is Equity Diversification Sufficient to Achieve Desired Returns?
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• Many investors think of diversification within the equity asset class.
• The common belief is that if one holds 30 stocks in varying sectors, the portfolio is diversified. It is fair, as depicted by the
graph below, that much of the idiosyncratic risk can be minimized by this type of portfolio.
• However, if the entire economy underperforms, then the best you can do with this strategy is to find stocks that will
weather the storm better than the broader market. You will still experience negative returns related to market declines.
• This curve underestimates the likelihood that the basket of stocks will largely trade together precisely when an investor has
the greatest need for the effects of diversification.
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4. Asset Class Diversification
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• For a portfolio to withstand market fluctuations, it is not
enough simply to have multiple stocks.
• Adding asset classes such as bonds and alternative investments
will greatly reduce overall portfolio correlations and provide
investors with the diversification necessary to weather the
storm of a bear market.
• Diversification is especially important as equity markets appear
more expensive following a long bull market run. In the past,
these conditions have often led to muted equity returns causing
investors to look to bonds. With fixed income yields near
historical lows and the Fed about to begin an interest rate
tightening cycle, we currently believe most fixed income
investments do not offer an attractive risk/reward profile.
• Accordingly, we believe liquid alternatives in the form of market
neutral strategies, long/short funds and other uncorrelated
investments offer an opportunity to:
• Diversify portfolios;
• Lower correlations;
• Add downside protection; and
• Provide more favorable long-term risk-adjusted returns.
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Correlation to YTD
S&P 500 Index Performance %
Benchmarks
S&P 500 INDEX PR 1.00 1.6%
BARCLAYS US AGG BOND INDEX -0.29 0.7%
BARCLAYS HIGH YIELD BOND INDEX 0.67 -2.8%
BW Example Liquid Alts
STRATEGY #1 0.67 2.8%
STRATEGY #2 0.38 3.1%
STRATEGY #3 0.23 11.0%
STRATEGY #4 0.23 17.9%
STRATEGY #5 0.00 4.5%
Source: Bloomberg
Security
Asset Class Benchmarks vs. BW Liquid Alternatives
from 12/31/2014 to 12/04/2015
• The table shows the equity correlations and returns of
major benchmarks versus our sample basket of liquid
alternatives. During this period, the basket provided
both lower equity correlations and higher returns than
both bonds and equities.

5. Conclusion: Diversification within the equity asset class is often misused as a “safety blanket” that
investors believe will protect them during poor investing climates. We think a properly diversified
portfolio should be able to weather the storm by providing downside protection in difficult
market environments. As we have discussed, the alternative space is uncorrelated and therefore,
offers the most attractive risk/reward metrics at the current time. We remain excited about the
opportunity set going forward regardless of the investment climate.
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Market Perspectives – December 2015
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6. Experience Insight Impact
Disclaimer
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Opinions expressed in this commentary may change as conditions warrant and is for informational
purposes only. Information contained herein is not intended to be personal investment advice for
any specific person for any particular purpose. We utilize information sources that we believe to
be reliable but cannot guarantee the accuracy of those sources. Past performance is no guarantee
of future performance; investing involves risk and may result in loss of capital. Consider seeking
advice from a professional before implementing any investing strategy.