Sometimes having fewer managers can actually improve risk/return alignment, argues AllianceBernstein's Patrick Rudden.

Typically, big investors attempt to mitigate the risk of a manager underperforming by using several professional managers to run their portfolios. Traditionally, this diversification process centres on the actively managed parts of the portfolio, leaving any passively managed assets in the hands of a single firm. But this conventional wisdom is back to front. There is good reason to argue investors should diversify their exposure to passive managers, while diversifying their exposure to active managers less.

Let's take the passive side first. Running index funds may look simple, but there is still plenty of risk involved, both organisational and operational. Trading massive volumes of possibly illiquid stocks at very specific points -often on a single day around closing prices - can magnify risks and leaves very little margin for error. 

There may be doubts, too, about the quality of those trades. The SEC is investigating several large custodians in the US - which are also large passive managers - over the way they executed foreign exchange deals for clients. Moreover, there are risks with what they do with the stock while it's under their control. Some index funds were active stock lenders in the run-up to the financial crisis, but the market upheavals led to several of them suffering significant losses on securities they had lent, which hurt clients in some cases.

By using several passive managers, all these risks can be easily diversified. It's relatively inexpensive too. Dividing institutional-sized passive mandates among two or three managers is likely to increase asset management fees by only a basis point or two.

What about the active side of an investor's portfolio? Taking that same cost point first, it goes without saying that dividing a large portfolio among several active managers can drive up fees substantially, since larger portfolios typically command fee discounts. So any diversification here needs to work harder to pay its way than where passive managers are involved. Yet there may be unintended investment consequences of using two or more active managers in any given asset class.

Clearly the hope is that by selecting managers that deploy different investment approaches the investor will benefit from greater diversification. Let's test that by considering a case where the investor has appointed two equity managers for mandates of equal size. The two portfolios have completely different holdings, except for stock X. Both have positions in stock X that are 1 percentage point larger than the stock's benchmark weight.

In the combined portfolio, any under- or overweight that existed in any one of the portfolios on its own is diluted by the process of bringing them together. So, for instance, a 2% overweight in one portfolio might become a 1% overweight in the whole. However, this is not the case with stock X, where that 1% overweight continues through to the enlarged portfolio.

The net result is that this overweight in stock X ends up dominating the risk profile of the combined portfolio. In the example shown, which was drawn from a particular stock in a particular index, it would account for 9.4% of the risk derived from the combined portfolio's divergence from its benchmark ('active risk'), even if it were only 4.1% and 7% of the active risk in the two separate portfolios.

If enough managers are involved, the result could be the unwitting creation of a quasi-index fund with a handful of outsized and unintentional stock-specific risks. In other words, while the objective was to further diversify risk, in practice the investor has further concentrated it.

This problem could be mitigated in several ways. The investor could introduce an overlay to manage the unintended consequences of overlapping positions. This might well be worth doing, but the investor would need to be aware that it would create another layer of fees.

Or the investor could try to select managers that are very different. Even then, the risk of overlapping security positions amplifying unintentional stock-specific risk would still increase with the number of managers. A much simpler solution would be just to limit the selection of active managers within each asset class.

Whatever the case, before they decide, investors need to think carefully through the issues involved in manager diversification. Sometimes, counter-intuitively, fewer managers can actually lead to a better alignment of risk and return.

Patrick Rudden is head of blend strategies at AllianceBernstein