How Much is Enough? Diversification across Mutual Funds

Abstract

This paper analyzes two major constraints placed on investors when implementing diversification across mutual funds. First, diversification is considered in a benefit/cost context. As long as the marginal benefit obtained from diversification is larger than the cost associated, it is worthy of increasing the diversification level for fund investors. Second, several risk statistics are examined as the number of funds in the portfolio increase. Diversifying across mutual funds substantially reduces portfolio standard deviation, kurtosis and VaR but also causes an undesirable decrease in return skewness. As such, the goal of an investor who wants to increase skewness would be to hold a less diversified portfolio. Jointly depending on the above two constraints, I suggest that a moderate level of diversification across mutual funds, say, a five-fund portfolio, can achieve most of the advantages associated with diversification.