That Isn’t Diversification – Part 1

One of the few free lunches ever to exist in investing is the concept of Diversification. There are two applications of diversification that relate to the retail investor, one of which is the responsibility of the asset manager, and the other, the responsibility of the wealth manager. Here we will cover the diversification expected (and unexpected) from asset managers.

Academically, diversification is discussed in the context of the asset manager. Adding additional securities to a portfolio reduces the idiosyncratic risk (upside or downside) that any individual security poses to the portfolio. Obviously, the fact that diversifying reduces both upside and downside risk makes it a double-edged sword.

Mutual funds often have upwards of 80 different securities in equity portfolios, and hundreds or even thousands within fixed-income portfolios. For fixed-income investments with a primary focus on yield, this very high number of securities makes sense – why not limit idiosyncratic downside risk across as many similarly-yielding bonds as possible? Since performing bonds go out at par, it isn’t like there is much upside risk to capture.

Equities are a different story. Given the fact that the return distribution of equities is negatively skewed, some diversification is a no-brainer (i.e. reducing more-likely downside risk at the cost of less-likely upside risk is a good trade). However, asset managers who exceed the 30-stock count, the point at which the vast majority of diversification’s benefit has been implemented, begin to trend more and more toward being closet indexers. There is nothing worse than what is tantamount to a passive strategy charging active management fees. Perhaps surprisingly, investors are to blame for this.

Active equity mangers know they won’t get fired (indirectly, by investors) unless they end up in the bottom decile of performance, and so they choose to add many more names to their portfolios than their skill or conviction would suggest, in order to hug their index and end up “right in that meaty part of the curve”. “Not showing off, not falling behind,” to quote George Costanza, is the approach that provides the most job security.

But these are precisely the managers who should be fired. Going back to our discussion on active vs. passive, if an active manager is charging standard active management fees, but is not generating any alpha, then investors are much better off indexing or finding a worthwhile manager. By only firing managers who end up in the bottom decile, a result that may come from taking risks that eventually pay off, investors have conditioned much of the asset management industry to hug their indices, keep collecting fees, and hope no one notices.

The asymptotic curve that maps additional securities on the x-axis and decreasing idiosyncratic risk on the y-axis was explained to me years ago by a highly successful equity portfolio manager with billions of client dollars under management. This PM explained that the small reduction in risk that is associated with increasing a portfolio from 30 to 80 securities has a name – a career. Investors should consider alpha generation and the number of securities in a portfolio at least as much as raw performance before deciding which managers to fire.

The free lunch that Diversification brings to a portfolio has diminishing, and eventually negative, returns to scale when you factor in the active management fees associated with implementing it. The number of securities in an equity portfolio should be negatively correlated with fees and expenses, and if it isn’t, should serve as a serious red flag. Closet indexing is not Diversification.

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