The Dangers of Diversification: Managing Multiple Manager Portfolios

Abstract

Investors have long built portfolios diversified across managers and have long applied mean–variance analysis to allocate to managers. This classic approach has at least three challenges. First, and most important, it concentrates risk in generic ideas correlated across managers. This can lead to unexpected tail risk. Second, it provides a temptation to overlever the resulting portfolio, which often appears to have very low risk but a high information ratio. Third, it typically combines underlying funds managed for standalone performance rather than performance of the portfolio, often leading to overdiversification. The authors analyze these three challenges and propose solutions. Unfortunately, the solutions are not easy to achieve.

TOPICS: Portfolio construction, manager selection, tail risks, risk management