Can You Be Too Diversified?

Diworsification
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 indexes.

Note, too, that converging toward 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?

Getting Cheaper
Echoing two of my recent themes--that investors are voting with their feet for cheaper mutual funds and that 401(k) plans are improving--Fidelity yesterday stated that it will be offering new, cheaper share classes for 16 of its Advisor series funds. The new Z share class (What's next? Alpha share class?) undercuts the company's existing Institutional share class by 15-20 basis points. It was created in response to pressure from 401(k) plan sponsors and will be offered into the retirement market.

For now, those share classes will only appear in larger 401(k) plans; small plans continue to struggle with high costs. But it's noteworthy to see new fund share classes being issued with stripped-down fees. Ten to 15 years ago, the trend was the opposite, as new share classes typically contained higher 12b-1 fees than their predecessors. I call that progress.

Heating Up
Recently, T. Rowe Price announced that it will launch a second, more-conservative series of target-date funds. One response: "In 'Dante's Inferno,' the hottest place in Hell is reserved for those who won't take a stand," says Ron Surz, president of Target Date Solutions. "Moving down to 42% [equities] at the target date is still pretty risky. I think [T. Rowe Price is] not getting the idea."

For his part, Surz recommends a 0% weighting in stocks at the target date. Some might say that there's a warm place in Hell for those who offer extreme investment solutions. Not me, of course, but some.

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

John Rekenthaler has been researching the fund industry since 1988. He is now a columnist for Morningstar.com and a member of Morningstar's investment research department. John is quick to point out that while Morningstar typically agrees with the views of the Rekenthaler Report, his views are his own.