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Is Three a Crowd? Considering the Value of Manager Diversification for Adding Alpha

Creating a portfolio that consistently generates alphaâ€”market-adjusted abnormal returnsâ€”is the holy grail of active management. Given that excess returns can come both from manager skill and from luck, some advocates of active management suggest that active funds should be combined into diversified portfolios, eliminating all but pure active risk and thereby optimizing the risk/return trade-off. In this paper, we present a simple model of such a diversified portfolio, and show that under certain conditions a portfolio manager actually would be better off by not diversifying.