In the investment world, diversification has always been a cornerstone of good portfolio management. We believe in it and advise our clients to diversify their portfolios across asset classes and investment strategies. But can there be too much diversification? We think the answer is yes.
In some ways, active management is the antithesis of diversification. In active management, investors hold overweight positions in some parts of the market and underweight in others. Investors who hold any type of active strategy, including most forms of alternative investments, are asking their managers to make bets on their highest conviction ideas. Too much manager diversification may turn active management into closet indexing (passive returns minus the fees).
If your active managers hold many securities that span the market broadly, they will never deviate far from the benchmark, and they will have a hard time outperforming their fees. If you don’t believe in your managers enough to give them the latitude to hold concentrated positions, then maybe you’d be better off with lower fee passive managers. (We wrote about this in our white paper Conviction in Equity Investing).
Similarly, the performance of hedge fund strategies are largely tied to manager skill, so is it really ideal for hedge fund of funds to hold 50-100 different hedge fund managers? Only, perhaps, if you have a strong aversion to hedge fund manager-specific risk. Maybe it would be better if they used a smaller number of managers—only those in which they have the highest conviction. This is especially true when the fund of fund investors have small allocations to hedge funds: do you really need a fund of funds with 50-100 hedge funds if your hedge fund allocation is only 5-10% of your total portfolio?
And with private equity, it may be overkill to diversify by manager, vintage year, geography, capitalization and other factors when the private equity is only a small fraction of the overall portfolio.
But there may be good reasons to have such high levels of diversification. For example, while we mentioned that there may be less need to diversify hedge funds and private equity when they are small fractions of the overall portfolio, there may be important benefits to having these asset classes sufficiently diversified to be stand-alone portfolios. This is because a single bad year might prompt an impatient Investment Committee to hastily exit the asset class; more diversified exposures can reduce the likelihood of that happening.
This type of behavioral rationale is worthwhile to consider, and it is important to realize that it has a cost. It means investing in more different things (potentially with more managers), some of which are not your absolute highest conviction ideas.
Like many things, diversification requires balance: not too much and not too little. Good portfolio management is not just about knowing when to diversify, also but knowing when to emphasize your best ideas.
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