Actively-managed mutual funds are not created equally. Performance can vary significantly – even when funds pursue similar strategies or “styles.”
This article addresses the impact on portfolio diversification of holding more than one actively-managed mutual fund. (For the companion article to this, see: How many mutual funds are needed for a well-diversified portfolio? – a commentary)
In “How Many Mutual Funds Constitute a Diversified Mutual Fund Portfolio?,” Professor Edward O’Neal of the University of New Hampshire at Durham tackled the important question of how much an investor could improve on diversification by holding multiple mutual funds in an investment portfolio.1 While there are large numbers of studies addressing the “how many common stocks” question, there are few that address the “how many mutual funds” question. Professor O’Neal’s is the best study on this subject that The Skilled Investor has yet found.
Holding multiple actively-managed mutual funds tends to reduce the volatility or risk of your long-term investment portfolio.
Professor O’Neal used Morningstar data for all U.S. “growth” style and “growth and income” style mutual funds that were in operation throughout the 1976 to 1994 period. For the full 19-year period, respectively, there were 103 and 65 of these mutual funds. He estimated the cumulative returns and volatility of investment portfolios that were composed of between one and thirty randomly selected mutual funds over various periods ranging from five to nineteen years.
Concerning his study methods, for a portfolio with a single fund, Professor O’Neal assumed an initial $1 investment and calculated compound returns and volatility quarterly and at the end of multi-year periods. Then, he averaged returns across all mutual funds of the same style. For portfolios of between two or more – up to thirty – mutual funds, Professor O’Neal randomly selected mutual funds to hold through the end of the investment period. Initially, he distributed $1 evenly across these funds. On a quarterly basis, he rebalanced equally across them. For each combination of 1) number of funds, 2) investment period, and 3) growth versus growth-and-income funds, he ran 1,000 simulations and averaged the cumulative returns and volatility.
The two tables below transform certain data from the many detailed tables available in this excellent study.2 The Skilled Investor assumes a normal distribution in estimating the dollar ranges in these tables. Therefore, the dollar ranges in these tables are probably close to but not exactly the same as the actual [...]