The Fallacy of Manager Diversification – How “Horse Races” Can Increase, Not Reduce Risk

March 5, 2019 |
2 minute read

On the surface, hiring two (or more) multi-asset managers to manage an entire portfolio may seem like a good idea. Intuitively, it would seem to reduce manager concentration risk, and provide Investment Committees with different investment outlooks and an easy performance comparison. In fact, it is not rare for committees to create these so-called “horse races”. But, instead of reducing risk, such institutions may inadvertently be creating unwanted risks in the portfolio.

Where’s the Risk?

Manager performance and risk comes from three sources:

  1. market (beta) exposure;
  2. factor exposure; and
  3. manager skill (alpha).

Ideally, a portfolio should be managed to a pre-determined beta exposure level (i.e., your strategic asset allocation) and diversified along factor and alpha dimensions.

Considerations in Portfolio Construction

Sources of Return and Commonfund Framework

Source: Commonfund. For illustrative purposes only.

Achieving desired market (beta) exposure begins with implementing strategic asset allocations (e.g. equities versus fixed income) and is seemingly straightforward. But it’s not always simple as, for example, fixed income managers can often have disguised equity beta exposure in their portfolios, typically in high yield and distressed strategies that carry risks that are correlated to the equity markets. In a horse race where market betas are not measured and managed on a total portfolio level, this can lead to more equity market exposure than the investment policy might specify.

Factor exposures (also known as risk premia) are less understood, and many times managers lump returns from factor exposures in with alpha. So, what are common factor exposures? Today, there are scores of identified factors, but among the most common are size and value. Size relates to market capitalization, i.e. small cap versus large cap. Value relates to style, defined as relative valuations based on a measure like price-to-book, i.e. value stocks versus growth stocks. Importantly, the returns resulting from these exposures, factor timing aside (which is notoriously difficult), are not the result of manager skill (alpha). Rather they are risk exposures that one is willing to accept for a commensurate return. For example, small-cap stocks tend to have higher risk and over long periods of time, investors have earned a premium for that risk compared to large-cap stocks. In a horse race, the factor exposures of each manager are not controlled and can result in unwanted concentrations or simply an expensive index fund. In contrast, a total portfolio level approach can lead to more informed risk exposures and lower costs.

The final source of return and risk is the most elusive – alpha, or true manager skill. Here, too, it is important that the sources of manager alpha are differentiated. Consider a typical horse race that includes two multi-manager firms. One risk is that both managers allocate to some of the same underlying sub-advisors in the portfolio, which can create a concentration risk on the source of manager alpha. Alternatively, each manager could be making opposite bets in their portfolio, thereby cancelling each other out. The potential for unintended consequences in a horse race are numerous. A portfolio level approach whereby sub-advisor allocations are considered based on their contribution of risk to the portfolio can mitigate these unintended consequences.

Concentrate to Diversify

The natural question remains, can Investment Committees concentrate and still feel appropriately diversified? We believe so and suggest the following check list:

  • Consolidating portfolio oversight and management with a single provider, as long as that provider allocates to independent sub-advisors – and not proprietary product – is a first step.
  • Second, managing risk on a portfolio level (not asset level) is vital, and press your advisor to provide sub-advisor level risk and return transparency.
  • Third, be wary of advisors that seek to generate significant sources of return from tactical asset allocation (TAA). Our view is that an overly weighted “house view” expressed in TAA can overwhelm contributions by sub-advisors.
  • And finally, to mitigate operational and enterprise risk concentration, diligence your advisor’s back office, its controls, audit procedures and independent custody operations.
Keith Luke


Keith Luke

Stay connected with the Insights Blog

Popular Blog Posts

Market Commentary | Insights Blog

Chart of the Month | The Surprising Relationship Between Money Supply and Inflation

The potential for rising inflation is becoming a top concern for many investors and consumers. Many believe that inflation is already here as evidenced by price increases in commodities, homes,...
Perspectives | Insights Blog

The Case for Using the Higher Education Price Index® (HEPI) to Define Inflation for Colleges

When calculating return targets for an endowment portfolio, a conventional piece of the equation is often the Consumer Price Index (CPI). CPI plus 5% is the common short-hand formula for institutions...
Governance And Policy | Insights Blog

Endowment Management and the Three Primary Responsibilities of a Board

The fourth blog in the “Six Ps of Investment Stewardship” series addresses People, specifically how boards function within an organization. To learn more about the first four principles in the series...


Certain information contained herein has been obtained from or is based on third-party sources and, although believed to be reliable, has not been independently verified. Such information is as of the date indicated, if indicated, may not be complete, is subject to change and has not necessarily been updated. No representation or warranty, express or implied, is or will be given by The Common Fund for Nonprofit Organizations, any of its affiliates or any of its or their affiliates, trustees, directors, officers, employees or advisers (collectively referred to herein as “Commonfund”) or any other person as to the accuracy or completeness of the information in any third-party materials. Accordingly, Commonfund shall not be liable for any direct, indirect or consequential loss or damage suffered by any person as a result of relying on any statement in, or omission from, such third-party materials, and any such liability is expressly disclaimed.

All rights to the trademarks, copyrights, logos and other intellectual property listed herein belong to their respective owners and the use of such logos hereof does not imply an affiliation with, or endorsement by, the owners of such trademarks, copyrights, logos and other intellectual property.

To the extent views presented forecast market activity, they may be based on many factors in addition to those explicitly stated herein. Forecasts of experts inevitably differ. Views attributed to third-parties are presented to demonstrate the existence of points of view, not as a basis for recommendations or as investment advice. Market and investment views of third-parties presented herein do not necessarily reflect the views of Commonfund, any manager retained by Commonfund to manage any investments for Commonfund (each, a “Manager”) or any fund managed by any Commonfund entity (each, a “Fund”). Accordingly, the views presented herein may not be relied upon as an indication of trading intent on behalf of Commonfund, any Manager or any Fund.

Statements concerning Commonfund’s views of possible future outcomes in any investment asset class or market, or of possible future economic developments, are not intended, and should not be construed, as forecasts or predictions of the future investment performance of any Fund. Such statements are also not intended as recommendations by any Commonfund entity or any Commonfund employee to the recipient of the presentation. It is Commonfund’s policy that investment recommendations to its clients must be based on the investment objectives and risk tolerances of each individual client. All market outlook and similar statements are based upon information reasonably available as of the date of this presentation (unless an earlier date is stated with regard to particular information), and reasonably believed to be accurate by Commonfund. Commonfund disclaims any responsibility to provide the recipient of this presentation with updated or corrected information or statements. Past performance is not indicative of future results. For more information please refer to Important Disclosures.