How Many Mutual Funds Constitute

a Diversified Mutual Fund Portfolio?

EdwardS. O'Neal

Can investorsreceivediversification benefitsfrom holdingmorethan a single

mutualfund in theirportfolios?Simulationanalysisshowsthat the time-series
benefitsare minimalbut thattheexpecteddispersionin terminal-
diversification
periodwealthcan be substantially reducedby holdingmultiplefunds.Portfolios
withasfewasfourgrowthfundshalvethedispersion in terminal-period
wealthfor
5- to 19-yearholdingperiods.In addition,downsideriskmeasures declineasfulnds
areaddedto portfolios.Theseadvantages to multiple-fundportfolios
areespecially
meaningful forinvestorsfundingfixed-horizoninvestment goalssuchas retirement
orcollegesavings.

W ith the continued proliferation of mutual
funds and the integral part they play in many
investors' portfolios, the question of how many
mutual funds constitute a diversified portfolio
grows increasingly important. Since Markowitz's
(1952) seminal work on portfolio selection, several
researchers have examined the number of stocks
required to form a diversified equity portfolio.
Research addressing the corresponding question for
mutual funds is conspicuously lacking, however.
This relative void is likely propagated by the con-
ventional wisdom that most mutual funds hold
enough securities to eliminate unsystematic risk
from their portfolios. The fact remains, however, that
mutual fund performance, even within objective
categories, is highly variable. In 1994, for example,
the average growth fund tracked by Morningstar
returned -1.5 percent but the standard deviation of
returns to growth funds was 5.5 percent.
Using actual return data for mutual funds from
the past 19 years to conduct simulations, this
study's results with randomly selected mutual
fund portfolios suggest that diversification across
funds even within investment objective can benefit
investors.
Studies of how many stocks are required to
diversify a portfolio generally measure the benefits
of diversification by the reduction in the time-series
standard deviation afforded by incrementally add-
ing randomly chosen stocks to a portfolio. Evans
and Archer (1968) concluded that the bulk of diver-
sification benefits are achieved with only a few
Edward S. O'Neal is assistant professorof finance at
the University of New Hampshireat Durham.
stocks, calling into question the economic justifica-
tion of holding more than about 10 randomly se-
lected stocks in a portfolio. Tole (1982), using only
stocks recommended by brokerage firms, put the
number of stocks needed for sufficient diversifica-
tion at between 25 and 40. Statman (1987), assum-
ing the existence of a risk-free asset, similarly found
the number to be between 30 and 40 securities.
An average growth fund holds 78 securities
(the 50th percentile of Morningstar growth funds
in 1994). If investors increase their portfolios from
one to two such funds, they will approximately
double the number of stocks in their portfolios (i.e.,
in the best case, in which the two funds hold com-
pletely different portfolios). The marginal benefits
in terms of the reduction of time-series standard
deviation, however, are minimal in the presence of
such large numbers of securities. Indeed, the simu-
lations described in this article provide evidence
that the inclusion of multiple funds affects time-
series standard deviations of portfolio returns only
minimally.
Radcliffe (1994) proposed the use of an alterna-
tive measure of risk for mutual fund investors. He
called this measure the terminal-wealth standard
deviation (TWSD). Terminal wealth is defined as
an investor's wealth at the end of a specific holding
period. The terminal wealth depends on the inves-
tor's time horizon and the investments held. Two
investors with identical horizons and holding the
same fund(s) will achieve the same terminal
wealth. Two investors with identical horizons but
different investments will likely achieve different
terminal-wealth levels. This variability in terminal
wealth, caused by holding different investments, is
of prime interest, especially to long-term investors.
This expected variability in terminal wealth can be

Financial Analysts Journal *March/April1997 37

quantified by running a number of simulations for
a particular holding period and calculating the
standard deviation of the resulting terminal-wealth
levels. This measure is TWSD.
Many investors use mutual funds, especially
in retirement plans or college savings plans, to
invest for prespecified time periods. Risk as mea-
sured by time-series portfolio standard deviation is
less important to these investors than the variabil-
ity in ending-period wealth. This variability in end-
ing-period wealth is closely tied to the risk of a
shortfall between fund proceeds and the use in-
tended for those proceeds. Investors with specific
holding periods and specific threshold wealth re-
quirements are less concerned with quarterly or
monthly volatility than with the possibility that
their portfolio funds will fail to finance fully their
intended purposes.
In this empirical analysis, simulations were
run to examine the impact of holding various num-
bers of mutual funds on the expected variability of
investors' terminal wealth. Findings indicate that
increasing the number of mutual funds in a portfo-
lio from one to six can reduce the expected variabil-
ity of terminal wealth by 40-70 percent.
ANALYSIS
SIMULATION
The simulation analysis assumes that one specific
mutual fund objective meets an individual inves-
tor's investment needs. The primary reason for
holding the objective constant is to facilitate the
simulation, although that assumption may be close
to reality for many investors. Morningstar cur-
rently divides equity funds into 13 separate objec-
tive categories. An equity investor is likely to be
able to identify one category that corresponds to his
or her investment needs. In reality, many investors
hold funds that provide a mix of equity and fixed-
income objectives in their portfolios. The choice of
any particular mix, however, would be an arbitrary
one for this simulation. The purpose of this analysis
is to determine whether even among funds within
the same investment objective, enough variability
in performance is present to warrant holding sev-
eral funds as opposed to a single fund.
The simulation analysis was conducted in the
spirit of Radcliffe (1994, pp. 744-46). Quarterly
mutual fund returns were collected from the Morn-
ingstar OnDisc database. All mutual funds catego-
rized as growth or growth and income that existed
from 1976 to 1994 were selected. This process
yielded 103 growth funds and 65 growth and
income funds.
The simulations used three choice variables:
the objective (growth or growth and income), the
holding period (5, 10, 15, or 19 years), and the
38 ?Association for Investment Management and Research
number of funds (1-8, 10, 12, 14, 16, 18, 20, 25, or
30).1
The Baseline: Single-Fund Portfolios
In the case in which the fund portfolio consist-
ed of a single fund, the simulation was run 103
times for growth funds and 65 times for growth and
income funds, one trial for each fund. One dollar
was assumed to be invested in each fund at the
beginning of the holding period. The wealth at the
end of the holding period for each fund was calcu-
lated by compounding the quarterly returns for
that fund over the entire holding period. This pro-
cedure produced 103 (65) terminal-wealth levels-
one for each growth (growth and income) fund. The
TWSD was then calculated as the standard devia-
tion of the 103 (65) terminal-wealth levels. The
TWSD represents the dispersion of ending wealth
levels to which an investor is exposed by choosing
to invest in a single fund. For each fund in each
holding period, the time-series standard deviation
(TSSD) of the returns was also calculated. The mean
of these TSSDs in each holding period represents
the average time-series volatility an investor would
be exposed to by choosing a single-fund portfolio.
The strategy of investing in a single fund was used
as a baseline against which to compare multiple-
fund portfolio strategies.
Multiple-FundPortfolios
The following procedure was followed for the
multiple-fund portfolio simulation:
* One dollar is invested at the beginning of the
holding period.
* The dollar is equally divided among n ran-
domly chosen mutual funds.
* At the end of each quarter, the original dollar
plus (or minus) any investment return is rebal-
anced equally among the n funds.
* The wealth at the end of the final quarter of the
holding period is the terminal wealth of the
portfolio.
The simulation was repeated 1,000 times for
each combination of the choice variables. The
TWSD was then calculated as the standard devia-
tion of the 1,000 terminal wealths generated in the
simulations. Thus, a TWSD was generated for each
combination of choice variables. The TWSD mea-
sures the variability of terminal wealth to which an
investor is exposed when selecting a certain num-
ber of funds for a particular holding period.
For each randomly selected portfolio, the time-
series standard deviation of returns was also calcu-
lated. For each combination of choice variables,
1,000 TSSDs were obtained. These 1,000 TSSDs
were averaged to produce an estimate of the time
series volatility an investor might expect from
holding a particular size of portfolio.
Tables 1 and 2 summarize the results of these
simulations. Increasing the number of funds held
in the portfolio has little impact on average termi-
nal wealth for the 5- and 10-year holding periods.
For the longer holding periods, the increase in
funds had a slight negative effect on average termi-
nal wealth, which was caused by the existence of a
few stellar mutual funds in the sample. The average
growth fund return over the 19-year period was
1,502 percent, although the distribution is skewed
to the right (the range was 543 percent to 6,794
percent). For small portfolios, the inclusion of a
stellar fund had a large impact on the terminal
wealth. The larger the quantity of funds in the
portfolio, the more quarterly rebalancing reduces
the impact that compounding the returns of the
stellar fund has on overall portfolio returns. In
unreported simulations, in which portfolios were
not rebalanced, increasing portfolio size did not
negatively affect average terminal wealth.
The sample does contain a survivorship bias,
which helps explain the generally higher average
returns for smaller portfolios. Morningstar publish-
es data only on existing funds. Some funds, howev-
er, especially poor performers, ceased to exist during
the period and thus do not show up in the database.
Just as stellar performers have a greater effect on
portfolios with fewer funds, so too do funds that
perform extremely poorly. Thus, the survivorship
bias serves to overstate the terminal wealth reported
for all portfolios. This overstatement, in the presence
of rebalancing, is greater for portfolios with few
funds than for those with many funds.
The average TSSD of portfolio returns was re-
duced only slightly for portfolios holding larger
numbers of funds. For growth (growth and income)
funds, increasing the number of funds from 1 to 30
decreased the TSSD by approximately 9 percent (12
percent), regardless of the holding period. This find-
ing is consistent with previous studies of time-series
diversification. Because most funds hold more than
60 securities, minimal time-series diversification
benefits are expected from adding more securities
(through additional mutual funds) to the portfolio.
The TWSD decreased significantly as the num-
ber of funds in a portfolio increased. The decrease
was evident for all holding periods and for growth
as well as growth and income funds. To gauge the
percentage reduction in TWSD, each TWSD was
standardized by dividing by the TWSD for single-
fund portfolios for each holding period. The results
are presented in Table 3 and graphed in Figures 1
Financial Analysts Journal * March/April1997
and 2. The reduction in TWSD attainable by adding
funds to a portfolio appears to be greater for growth
funds than for growth and income funds. For
growth funds, a six-fund portfolio reduced TWSD
to between 31 percent and 41 percent (depending
on the holding period) of that expected for single-
fund portfolios. For growth and income funds,
holding six funds reduced TWSD to between 47
percent and 52 percent of single-fund portfolios.
The reduction in TWSD is greater over all holding
periods for growth funds than for growth and in-
come funds. Growth funds as a group display
greater dispersion in terminal wealth than growth
and income funds, which may cause multiple-fund
portfolios to exhibit greater dispersion reduction.
This result suggests that more aggressive investors
have the most to gain by diversifying across funds.
The difference in TWSD reduction was gener-
ally greater the longer the holding period. The only
exception is that for growth and income funds,
multiple funds afforded better terminal-wealth di-
versification in the 5-year period than in the 10- and
15-year periods. In all cases, the marginal benefit of
successively adding funds to the portfolio de-
creased as the number of funds increased.
To determine whether the reduction in TWSD
varies across time for identical holding periods,
three additional five-year periods were examined.
The five-year holding period data documented in
Tables 1 through 3 are for the 1990-94 period. The
simulations were duplicated for the 1976-80,1980-
84, and 1985-89 periods for growth funds. Results
for the reduction in TWSD for each holding period
are graphed in Figure 3. The time period does not
appear to have a large impact on the reduction in
TWSD. For a six-fund portfolio, the reduction in
TWSD ranged between 36 percent and 42 percent
of that expected with a single-fund portfolio for the
four time periods.
MEASURESOF DOWNSIDERISK
The dispersion in ending-period wealth levels, as
measured by the TWSD, takes into account positive
as well as negative deviations from the mean. Inves-
tors, however, may not view deviations on the pos-
itive side as contributing to the riskiness of a mutual
fund portfolio. Further, if the reductions in TWSD
achieved by holding multiple-fund portfolios come
mainly by truncating the upside of the distribution,
the benefits of multiple-fund portfolios may be
overstated. Three measures of the downside risk of
terminal-wealth levels were examined as the num-
ber of funds in a portfolio is varied.
39
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Financial Analysts Journal * March/April1997 41

 Harlow (1991) identified several measures of
downside risk that may be more intuitive than Mean shortfall =
f, n (2)
1=1
traditional risk measures. The first of these, short-
- 2
fall probability, measures the likelihood that an
"(xl.- x) 3
investment's returns will fall below a specific tar- Semivariance= ___ , 3
get return. In the simulation analysis, the mean
return was used as the target, and shortfall proba- where
bility can be calculated by finding the percentage
x.
xi,ifxix.
of simulations that display terminal-wealth levels
x, if xi > x .
below the mean:
Each of these measures depends on the mean of the
Shortfallprobability = distribution. For the 15- and 19-year holding peri-
Number of observationsbelow the mean ods, the mean terminal wealth was slightly higher
n for the single-fund portfolios than for the multiple-
fund portfolios, as illustrated in Table I. Therefore,
where n is the total number of observations. a strict application of the equations for each num-
The major shortcoming of shortfall probability ber of funds will penalize single-fund portfolios.
as a risk measure is that it does not account for the The higher mean will increase all three downside
magnitude by which returns fall short of the mean. risk measures relative to a distribution with a lower
Two other measures address the magnitude of mean. The higher mean is a benefit to single-fund
shortfall. Harlow considered target shortfall that portfolios. Because the purpose of this study is to
measures the deviation from a target of those ob- quantify any benefits to multiple-fund portfolios
servations that are below the target. This method vis-a-vis single-fund portfolios, the calculations of
characterizes as more risky those distributions that the downside risk measures for all multiple-fund
have large downside deviations from the target. portfolios assume the mean terminal wealth for the
For the simulation analysis, the target was the mean single-fund case. For the growth fund sample, the
of the fund portfolio returns. 2 three downside risk measures were calculated for
5-, 10-, 15-, and 19-year holding periods. Results are
Semivariance is a very similar measure. It mea-
shown in Table 4.
sures the squared deviation from the mean of those
Shortfall probability was relatively stable for the
observations that are below the mean. This mea- shorter holding periods (5 and 10 years) as the num-
sure, as with variance, gives greater weight to those ber of funds increased. For the longer holding peri-
observations that are farthest from the mean. When ods, shortfall probability increased with the number
measuring downside risk, this weighting may be of funds in the portfolio. This finding is likely the
appropriate because investors are most averse to result of survivorship bias in the data. The few stellar
those largest downside deviations. Equations 2 and funds in the sample increased the mean terminal
3 detail the calculation of mean shortfall and semi- wealth most for the single-fund portfolios. The dis-
variance. tributions of the multiple-fund portfolios exhibit a
Table 3. Terminal-Wealth Standard Deviation as a Percent of Single-Fund PorffolioTerminal-Wealth
Standard Deviation by Type of Fund and Holding Period
Holding Period: Growth Funds Holding Period: Growth and Income Funds
Number
of Funds 5 Years 10 Years 15 Years 19 Years 5 Years 10 Years 15 Years 19 Years
1 100% 100% 100% 100% 100% 100% 100% 100%
2 68 71 64 62 73 83 82 71
3 56 55 51 46 72 77 76 63
4 50 48 45 40 61 67 66 54
5 43 45 40 35 59 63 61 50
6 41 40 38 31 52 59 57 47
7 38 36 33 29 49 53 52 42
8 35 35 32 28 46 51 49 41
10 31 30 28 25 40 44 46 38
12 28 28 26 21 39 43 43 34
14 27 27 23 21 37 38 40 32
16 25 25 22 18 32 37 37 29
18 23 23 22 18 32 34 34 29
20 22 21 20 17 30 33 32 27
25 19 19 18 15 26 29 30 25
30 18 18 16 14 25 26 27 21

42 ?Association for Investment Management and Research

 Figure 1. Reduction in Terminal-WealthStandard Deviation for GrowthFund
Porffolios over DifferentHolding Periods

110

100

90

80 -

70-
600

50
40

1
40

30
30 . ... ....
. .......l l l l

1 3 5 7 9 11 13 15 17 19 21 23 25 27 29
Number of Funds in Portfolio

5 Year -.IO Year ----15 Year 19Year

Figure 2. Reduction in Terminal-WealthStandard Deviation for Growthand

Income Fund Portfolios over DifferentHolding Periods

110

100 _

90 -

80 -

70 -
u 0

50

40

30

20-

10
1 3 5 7 9 11 13 15 17 19 21 23 25 27 29
Number of Funds in Portfolio

5 Year lO Year ----15 Year - 19 Year

Financial Analysts Journal * March/April1997 43

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44 ?Association for Investment Management and Research

 Figure 3. Reduction in Terminal-Wealth Standard Deviation for Growth Fund
Portfolios in Different Five-Year Holding Periods
110
100
90
80
70 -
t 60
30-
20 -
10
I I I I I II
0
1 3 5 7 9 11
Number of Funds in Portfolio
1990-94 ........*1985-89
central tendency around a mean that is less influ-
enced by the stellar performers (and hence slightly
lower than that of the single-fund portfolios). Be-
cause shortfall probability was calculated using the
single-fund mean, the central tendency (around a
lower mean) of the multiple-fund portfolios causes
an increase in shortfall probability.
Shortfall probability has the drawback of not
considering the magnitude of shortfall. Both mean
shortfall and semivariance overcome this weakness
(the square root of semivariance is reported in Table
4). Both of these measures decreased substantially
as more funds were added to the portfolio. For the
5- and 10-year holding periods, the mean shortfall
and semivariance 1/2 were reduced by at least half
by holding five funds in the portfolio. The longer-
holding-period results also displayed reductions in
these two measures, although they are less pro-
nounced than for shorter holding periods.
NOTES
1. The last year for each holding period is 1994. Thus the 19-
year holding period is 1976 to 1994, the 15-year holding
period is 1980 to 1994, the 10-year holding period is 1985 to
1994, and the 5-year holding period is 1990 to 1994.
2. Two alternative targets that also have intuitive appeal are a
zero-return target and a risk-free return target. The zero-
return target constitutes a "loss-of-principal" measure of
downside risk, and the risk-free return target benchmarks
performance against a riskless alternative investment. In the
current analysis, the vast majority of funds produce terminal
wealth levels that surpass both of these targets over each
investing horizon. Using the mean fund return as the target
provides a more quantifiable measure of downside risk
Financial Analysts Journal * March/April1997
II I I I I I I I
13 15 17 19 21 23 25 27 29
- - -- 1980-84 ^-- --1976-80
CONCLUSION
Holding more than a single mutual fund in a port-
folio appears to have substantial diversification
benefits. The traditional measure of volatility, the
time-series standard deviation, is not greatly influ-
enced by holding multiple funds. Measures of the
dispersion in terminal-wealth levels, however,
which are arguably more important to long-term
investors than time-series risk measures, can be
reduced significantly. The greatest portion of the
reduction occurs with the addition of small num-
bers of funds. This reduction in terminal-period
wealth dispersion is evident for all holding periods
studied. Two out of three downside risk measures
are also substantially reduced by including multi-
ple funds in a portfolio. These findings are espe-
cially important for investors who use mutual
funds to fund fixed-horizon investment goals, such
as retirement and college savings.3
reduction. It also minimizes the impact that survivor bias
may have on downside risk results. Although the sample
fund portfolio returns are likely to be biased upward, the
target is also biased upward because it is the mean of a group
of portfolios of surviving funds. If the target were zero return
or risk-free return, the surviving funds would display an
artificially high probability of surpassing the target.
3. The author thanks R. Ward Flintom for several insightful
discussions on these issues. Also deserving special acknowl-
edgment are David Bradford, Ahmad Etebari, Franklin Fant,
W. Van Harlow III,Miles Livingston, JeffLenz, and Economics
seminar participants at the University of New Hampshire.
45
REFERENCES
Evans, John L., and Stephen H. Archer. 1968. "Diversification
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46 ?Association for Investment Management and Research