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Overdiversification could be hurting pension plan performance – paper

A new article in the CFA Institute Financial Analysts Journal warns of the consequences of active manager overdiversification in U.S. pension plans.

Those consequences might include overall poor performance because the more active managers a plan uses within an asset class, the less the potential for outperformance, said Ric Thomas, global head of strategy and research for the investment solutions group at State Street Global Advisors, and lead author of the white paper, in a telephone interview.

"My team meets with a lot of institutional investors across the globe," Mr. Thomas said, "and we've been doing a number of research projects with clients doing a lot of risk analysis on their portfolios. They've been overdiversified and it kept coming up over and over and over again."

In the article, "What Free Lunch? The Costs of Overdiversification," Mr. Thomas and Shawn McKay and Robert Shapiro, senior investment strategists in the investment solutions group at SSGA, created two ratios to help investors determine the optimal number of active managers in an asset class. The FAR ratio — fees for active risk — is equal to the management fee divided by active risk, and the FAS ratio — fees for active share — is management fee divided by active share. Using the FAR equation, for example, if a plan hires nine uncorrelated money managers each with an active risk — the standard deviation of the excess return over the benchmark — of 6%, then the resulting active risk for that overall portfolio would fall to 2%. A lower active risk equals a smaller chance of outperforming the benchmark.

Active share is the percentage of stock holdings in a portfolio that differ from the benchmark.

The FAR and FAS ratios can help determine an optimal number of external managers, according to the authors. For example, assuming a plan finds 25 basis points of fees per unit of active risk (a 1% active risk level) acceptable and each underlying money manager runs a 4% active risk level and charges 50 basis points, the optimal number of managers might be four.

The article does note that numbers are "likely to change depending on the objectives and beliefs for each plan."