Can You Be Too Diversified?

John Rekenthaler looks at the argument that more is less

John Rekenthaler 19 June, 2013 | 5:17PM
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Consultants and fund marketers often talk about "diworsification." The pun is painful but it conveys the idea: There is such a thing as being too diversified. In the words of a consultant, "An active portfolio built primarily around long-only managers in efficient asset classes, especially if those managers employ a large number of positions, is much more likely to underperform a similar passive portfolio net of fees."(1) Some of the portfolio's actively run funds will fare well, some will be middling, and some will be poor. When it all washes out, the argument goes, the result will be average performance at above-average cost (relative to index investing.)

Note that the diworsification argument is not typically applied to the fund's beta--that is, to its asset allocation. Splitting the 5% of monies that a portfolio allocates to emerging-markets stocks among four managers, rather than giving all 5% to a single manager, will not worsen the portfolio's asset mix. Either way, the portfolio holds the same amount of that security type. Instead, diworsification involves alpha--the ability (or lack thereof) of a fund to outperform a basket of low-cost indices.

Note, too, that converging towards the middle is not necessarily a drawback. It's possible that a portfolio that concentrates its investments into a smaller number of funds might own mostly duds. (Of course, that would never happen to you or me, but consider your boss. He's dumb enough to buy a bunch of bad managers, no?) In such a case, diworsification would instead be "dibetterfication," as the additional funds would likely improve the portfolio's average performance. Reducing idiosyncratic risk cuts both ways.

The general prescription for avoiding diworsification is to concentrate. Concentration can be done both by holding fewer active managers and, when buying active managers, by seeking funds that have large positions in relatively few investments. However, these strategies only make sense for investors who satisfy two conditions: 1) They are willing to court additional idiosyncratic risk and 2) they have strong conviction (knowledge would be better yet) about the relative prospects of a small number of funds. Thus, investors who are unwilling to assume extra idiosyncratic risk should not be concentrated. Nor should those who lack strong conviction about the prospects of any actively managed funds. Finally, those who have strong convictions about many funds will also avoid concentration.

In short, the prescription for avoiding diworsification does not suit most investors. So if you stumble across the term, feel free to carry on without worrying--but do consider its implicit warning on fees! Costs kill all types of portfolios, diversified or not. But you knew that, right?

(1) Scott Welch, Fortigent http://www.fortigent.com/, no direct link as the article is firewalled.

The information contained within is for educational and informational purposes ONLY. It is not intended nor should it be considered an invitation or inducement to buy or sell a security or securities noted within nor should it be viewed as a communication intended to persuade or incite you to buy or sell security or securities noted within. Any commentary provided is the opinion of the author and should not be considered a personalised recommendation. The information contained within should not be a person's sole basis for making an investment decision. Please contact your financial professional before making an investment decision.

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John Rekenthaler

John Rekenthaler  John Rekenthaler is vice president of research for Morningstar.