Diversification means different things in different contexts. We can speak, for example, of diversification within an equity portfolio — i.e., of holding a number of stocks with potentially-offsetting risks, as opposed to concentrating on only one issue or on a handful of similar stocks. Or we can think of diversification across asset classes — e.g., by adding bonds, or international stocks, or commodities to a (diversified) U.S. equity portfolio. Conventional wisdom smiles on these two forms of diversification, and rightly so, since the final diversified portfolio typically has a higher expected return, or lower expected risk, than the starting portfolio.
But diversification might not always be a good idea. Suppose I go a casino, find the roulette wheel, and bet on a number at random. I’m likely to lose my money. If I do the same thing a second time, and a third, the result is likely to be the same. I haven’t created a diversified portfolio of bets — I’ve merely repeated the same mistake several times over.
A recent white paper asks whether the selection of active investment managers is a useful or fruitless form of diversification. (Spoiler alert: fruitless.) Why? Active managers, more often than not, underperform the indices against which they’re benchmarked. An investor who chooses an actively-managed fund over an index fund is therefore more likely than not to underperform. Adding a second and third actively-managed fund is likely to leave the investor worse off than he was with only one (just as multiple turns at the roulette wheel are likely to leave a gambler poorer than he was after his first bet).
If it were easy to find outperforming active funds, diversifying active management might be beneficial. But it’s not easy — and that implies, as discussed here, that picking active managers is one of those areas where diversification fails.