Hi Guys,
Over decades, one of Wall Street’s surviving maxims has been to diversify ….. diversify ….. diversify. That’s an especially wealth protection technique when the marketplace appears to be overvalued and an overdue correction is anticipated. There are always market Doomsayers and market Cassandras. Both are right, but only infrequently and never together.
On the one hand, Gerald Loeb said: “The really great fortunes were made by concentration, not diversification”. On the other hand, Jack Bogle contributed: “ Don’t struggle to find the needle in the haystack, just buy the haystack”. Choose your own poison, or perhaps Mark Skousen had it more nearer the truth with: “To make it, concentrate, to keep it, diversify.”
But like most things, the law of diminishing returns creeps into the equation when diversification becomes excessive. With too many mutual fund/ETF holdings, an actively managed portfolio takes on the character of a market portfolio, an Index equivalent approach except at a higher cost that erodes performance.
“Diworsification” is a word coined by Peter Lynch that addresses this issue. Lynch initially used diworsification to describe a company that expanded beyond its core competencies seeking extra income and profits.
More recently, the word is applied to ridicule folks who own more equity products than is necessary for real diversification. These excessive products hold overlapping stocks, and act to neutralize and cancel any active management Alpha insights.
Rick Ferri and others have demonstrated the futility of owning tons of actively managed mutual funds using Monte Carlo analyses. He has written a book on his findings; it is titled “The Power of Passive Investing”. Here is a Link to a Ferri Whitepaper that documents some of his results:
http://www.RickFerri.com/WhitePaper.pdfTo overly simplify his output, I’ll allude to a few general numbers that are representative of Ferri’s findings. On average, in any given year, about one-third of active managers will generate excess returns relative to a benchmark. These managers will produce about 1.5% excess rewards. The two-thirds of underperforming managers will produce a shortfall of perhaps about 2.0%, a major part due to costs. The asymmetry in quoted performance adequately captures the historical record.
Globally, the most likely excess returns is therefore, (0.333 X 0.015) + (0.666 X -0.020) equals a negative 0.00835 or roughly an unattractive downside gamble of 1%. That’s a bad deal. Those expected returns would be immediately rejected by most professional gamblers.
It’s indeed a bad deal unless you can a priori identify winning managers. But the odds of doing that decreases with the number of managers hired because the drawing is from a bag that has twice as many black marbles than golden marbles. The more you gamble, the more likely you will lose in the selection process.
Even the highly touted and extremely well paid Ivy League managers have suffered recent failures, especially if compared to Paul Farrell’s lazy-man portfolios. Here is a Link that reports on the stumbles made by this grand group:
http://pragcap.com/the-ivy-leagues-and-diworsificationThese current results do not portend well for the individual investor. If these well resourced professionals are experiencing such troubles just matching simple benchmark hurdles, the game is even tougher for the rest of us.
As a general rule, hiring more active fund managers, beyond numbers like those of Farrell’s array of Lazy-man portfolios, is more likely to subtract rather than add to a portfolio’s projected returns. Ferri’s Monte Carlo simulations clearly illustrate that issue.
Some MFO members should take especial note of these findings , and perhaps should adjust actively managed fund holding numbers downward accordingly. As always, whatever makes you most comfortable so that you “stay the course” is best for you.
Just today Ted has posted several Links that address this same issue.
Best Regards.
Comments
http://www.investmentnews.com/article/20140914/REG/140909933/why-managed-futures-arent-getting-the-job-done?utm_source=IssueAlert-20140914&utm_medium=in-newsletter&utm_campaign=investmentnews&utm_term=image#
Are you investing in passive or active mutual funds these days?
Mona