Manager Diversification: Why Conventional Wisdom Is Wrong

June 07, 2012

There’s a strong case to be made that investors should diversify their exposure to passive managers more—not less—than they diversify their exposure to active managers. 

Typically, big investors attempt to mitigate the risk of a manager underperforming by using several professional managers to run the actively managed parts of their portfolio, leaving any passively managed assets in the hands of a single firm. I believe that this conventional wisdom gets it the wrong way around. There is reason to argue for more diversification on the passive side than the active.

Let’s take passive first. Running index funds may look simple, but there is still plenty of risk involved. Trading massive volumes of possibly illiquid stocks at very specific points (often on a single day, around closing prices) can magnify risks and leave very little margin for error. 

There may be doubts, too, about the quality of those trades. Several large custodians in the US—who are also large passive managers—are being investigated by the SEC in connection with the way they executed foreign-exchange deals for clients. Moreover, some index funds were active stock lenders in the run-up to the financial crisis. Market upheavals led to several of them suffering significant losses on securities they had lent, which hurt clients in some cases. 

By using several passive managers, all these risks can be easily diversified. It’s relatively inexpensive, too. Dividing institutional-sized passive mandates among two or three managers is likely to increase asset management fees by only a basis point or two. 

What about the active side of an investor’s portfolio? On the question of cost, it goes without saying that dividing a large portfolio among several active managers can drive fees up substantially, since larger portfolios typically command fee discounts. Any such diversification therefore needs to work harder to pay its way, yet there may be unintended investment consequences of using several active managers in any given asset class. 

Let’s consider a case where the investor has appointed two equity managers for mandates of equal size. In the investor’s combined portfolio, any under- or overweight that existed in any one of the portfolios on its own is diluted by the process of bringing them together. So, for instance, a 2% overweight in one portfolio would become a 1% overweight in the whole. But this is not the case if both managers are overweight the same stock: that overweight will continue through to the enlarged portfolio.

The effect is that any single overweights carried over into the combined portfolio are reduced in size, while that of any duplicated overweight effectively increases. Indeed, duplicated overweights can end up dominating the risk profile of the overall portfolio. So, while the objective was to diversify risk further, in practice it’s been further concentrated. 

This problem could be mitigated in several ways. The investor could introduce an overlay to manage the unintended consequences of overlapping positions. This might well be worth doing, but the investor would need to be aware that it might create another layer of fees.

Or the investor could try to select managers that are very different. Even then, the risk of overlapping security positions amplifying unintentional stock-specific risk would still increase with the number of managers. We think a simpler solution would be to limit the selection of active managers within each asset class.

Whichever the case, before they decide, investors need to think carefully through the issues involved in manager diversification. Sometimes, counterintuitively, fewer managers can actually lead to a better alignment of risk and return.

The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AllianceBernstein portfolio management teams. 

Manager Diversification: Why Conventional Wisdom Is Wrong
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