Blog - Investing Notes

August 29, 2005 – Mutual Funds Underdiversified?

Under the U.S. Investment Company Act of 1940, a mutual fund must hold at least 16 stocks to be classified as "diversified." In their recent paper entitled "Optimal Number of Stock Holdings in Mutual Fund Portfolios Based on Market Performance", Hany Shawky and David Smith investigate whether there is an optimal number of stocks for a mutual fund, reflecting a trade-off between the benefits of diversification and the costs of transactions and monitoring. Do mutual funds tend to underdiversify or overdiversify? Using a filtered sample of 4,838 fund-years (distinct actively managed U.S. equity funds, excluding those underdiversified by design) from Morningstar over the period 1992-2000, they find that:

• The median number of stocks held is fairly stable in the range 57-72. The top 10 holdings consistently represent about one-third of total portfolio value. The number of stocks held tends to be relatively large when the median market capitalization of holdings is low.
• The median fund expense ratio remains constant over the period examined. The expense ratio tends to be relatively high when the number of stocks held is small.
• The median annual portfolio turnover varies from 54% to 79%. Portfolio turnover tends to be relatively high when the number of stocks held is large.
• Fund performance relates positively to the number of stocks held and negatively to the square of the number of stocks held. (See the chart below, adapted from the paper.) A rough estimate of the number of stocks in an optimally diversified U.S. equity fund portfolio is 480.
• Changes in the number of stocks held over time correlate better with the inflows/outflows of mutual funds than with their investment returns. When net fund flows are positive, managers tend to add new stocks; when negative, they tend to undiversify.

In summary, based on this model, most actively managed U.S. equity mutual funds are underdiversified. This analysis seems to argue for buying a broad index fund rather than an actively managed fund.

For related items, see:

Warren Buffett's comments on investment diversification;

Blog Synthesis: Mutual Funds and Hedge Funds; and,

Our blog entry of 3/16/05 for an argument against diversification for savvy individual investors.