Diversity Orthogonality Theory

Hi this is Cameron Height from Alpha Theory.

I recently wrote a blog post with my colleague Chris White where we talk about the benefits of lower correlation in manager returns. Specifically talking about how multi-managers when they pull together multiple good managers with correlations between their returns of less than one, you end up creating portfolios with good returns with very low volatility.

That low volatility allows you to leverage up the portfolio.

It's the benefits of the multi-manager model.

I think the benefits of diversity are well known, but we were wondering if there's also a benefit that comes from having managers that think differently. One way to make them think differently is to have folks from different backgrounds.

It's called the Diversity Orthogonality Theory, and we don't have a ton of data to prove it.

But it seems to make common sense that if I were constructing a portfolio of multi-managers, say I have 10 managers in one fund and 10 managers in another fund.

And now let's say that the 10 managers in one fund, generate on average 10% returns.

The 10 managers in the other fund generate on average generate 10% returns.

And let's imagine that these 10 have very similar backgrounds.

They've all worked for hedge funds before or maybe potentially work for multi-managers before.

They are very sensitive to the way their strategies are very similar.

They're thinking about earnings beats and misses.

And so, we've got this group here and then we have this other group over here and they have different backgrounds where you have folks that maybe have worked for multi manager. Folks that have maybe worked for long only funds. People that have worked for deep fundamental and potentially different socio-economic backgrounds as well, which will also change the way that you think.

And so, which of those two would be better?

Arguably, if the return profiles of both of those are the same, the one where you have a more diverse set of managers will get a lower overall correlation amongst those returns and a higher sharpe.

The idea here is that there's a benefit to society for having a more diverse group of folks that you're working with, but there also may be an economic benefit for doing it as well.

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