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Rekenthaler Report

Can You Be Too Diversified?

Let's look at the argument that more is less.

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.