How Many Mutual Funds Are Needed to Form a Well- Diversified Asset Allocated Portfolio?

Abstract

Funds of funds, which have become a popular investment vehicle in recent years, diversify across asset classes as well as managers with different styles and expertise. Lifecycle funds are a good example of funds of funds where investors can invest in a group of asset classes in different proportions depending on their investment horizon, risk tolerance, and objectives. Given that the number of mutual funds in the portfolios of lifecycle funds offered by different investment companies varies significantly even for those with similar targets, it is important to investigate the relationship between the number of mutual funds in an asset allocated portfolio and the resulting diversification benefits. As investors in lifecycle funds are concerned with the level of wealth they will have accumulated as of a target date, the variability of terminal wealth at the end of a given holding period is a relevant measure of risk for their portfolios. In this article the authors use a survivorship-bias-free sample to assess the impact of the number of mutual funds in an asset allocated portfolio on the variability and shortfall risk of its terminal wealth. Specifically, they run simulations to generate a large number of terminal wealth level outcomes for a portfolio with a given number of funds. Then, they obtain the frequency distribution of the terminal wealth outcomes, and use its dispersion as the risk measure in the analysis. The findings for three asset allocation scenarios, which are reported for 5-year and 10-year investment horizons, indicate that holding 10 to 12 funds in the portfolio instead of the minimum possible 2 funds as dictated by the asset allocation to equity and bonds reduces the standard deviation of terminal wealth by about 60%. This reduction can be obtained without sacrificing expected terminal wealth levels, and hence without a reduction in total returns. Similarly, the mean shortfall of terminal wealth and the semivariance of terminal wealth are reduced by 60% and 85%, respectively. <b>TOPICS:</b>Portfolio construction, long-term/retirement investing, wealth management