R06 and AF5 expected solutions

2. Investment article – correlation
The degree of diversification within a portfolio depends largely on the extent to which the investment returns are correlated.

Correlation of asset returns is important; a portfolio of assets with lower return correlations represents less overall risk for the investor.

The example often used to demonstrate correlation is where one company sells umbrellas and the other sells sunscreen (or ice cream or sunglasses, etc.). The company that sells umbrellas performs well when it rains but does not perform so well when the sun is out.  The reverse happens if the portfolio is solely invested in sunscreen - good performance in sunny weather and not so good when the raindrops appear.  This is an example of negative correlation, where the returns from two shares move in opposite directions.  This perfect negative correlation may be difficult to achieve, but it is worth looking for stocks that have as low a correlation as possible.

Correlation is expressed as a number between +1 and -1.

A correlation of +1 indicates perfect correlation (positive).

A correlation of -1 indicates an opposite relationship (negative).

A correlation of 0 indicates that there is no correlation.

Let’s now take this information and apply it to an R02 question.  You will usually be given a correlation table.  This table shows the correlation of each fund or asset to each other fund or asset.

Fund/Asset	A	B	C	D
A	1	+0.8	-0.2	+0.1
B	+0.8	1	+0.4	-0.9
C	-0.2	+0.4	1	-0.3
D	+0.1	-0.9	-0.3	1

If you look at fund/asset A shown in the first column and look at the first cell to the right – this shows a correlation of 1. This is because it is showing the fund/asset’s correlation with itself!  If you look at the next cell to the right, you will see +0.8 which is fund/asset B’s correlation to fund/asset A.  This is a high correlation figure meaning not good for diversification purposes.  The correlation of fund/asset C to fund/asset A is -0.2; a negative figure meaning the value for diversification purposes is good.

An R02 exam question might ask you to identify the two funds which represent the greatest positive correlation, in which case the answer here would be B and A at +0.8. Or you may be asked which two funds offer the greatest negative correlation, in which case the answer would be B and D.

3. Taking Continuous Professional Development seriously
The focus of the FCA is on advisers taking their CPD more seriously, and not just treating the requirement to keep their knowledge up to date as a tick-box exercise. We have designed our accredited CPD system to meet these requirements. Our CPD  information page includes articles and presentations to help advisers meet their CPD obligations and maximise the benefits from their CPD. We have also created this presentation: Which CPD camp are you in?

4. Panacea Adviser launches the second edition of its Guide to HR for IFA Firms
Following the success of it’s HR Guide in 2016, Panacea Adviser has launched a second edition, to include new rules and regulation to HR policy including tax-free childcare benefits and auto enrolment. 

This complimentary handbook can help with any human resource ambiguity and should be used as your go-to reference manual to effectively manage HR. Download it for free today at www.panaceaadviser.com/hrguide.