How Much Diversification is Enough?

# of stocks in portfolio diversificationStudies have shown that diversification benefits diminish after 30 stocks in a Portfolio.

Source: DeMarzo, Peter, and Jarrad Harford. “Chapter 12 Systematic Risk and the Equity Risk Premium.”

However, some investment managers add more and more securities to portfolios as they raise assets. The practice of adding too many securities for diversification purposes has significantly diminishing results on risk reduction. While diversification has many benefits, the process of adding too many securities can have the effect of “diworsification“.

This practice can have the effect of producing “closet index strategies”. When analyzing investment strategies you want to make sure you are not paying active management fees for a strategy that basically mimics its benchmark. Thankfully there is a metric that can be analyzed to see how “active” a manager is. “Active Share” measures the percentage of a portfolio’s holdings that differ from its benchmark. A low active share could be problematic because it may limit the ability to outperform. Conversely, higher active share has the potential to identify managers who are more likely to outperform over time. The use of “active share” in addition to other analysis techniques such as factor tilting toward value, quality or momentum has the potential to not only avoid underperforming funds but identify ones more likely to provide outperformance in the future.

In a 2006 paper by Cremers and Pegajisto of Yale, they examined 2,650 mutual funds from 1980 to 2003. They found that those funds with an “active share” of 80% or higher beat their benchmark indexes on average by 2% to 2.71% before fees and 1.49% to 1.59% after fees, per year. Active management has the potential to outperform benchmarks over time, but it must be truly “active”. In addition, the authors found that those that consistently outperformed were extremely disciplined within their strategies and held their securities much longer than average (through periods of weakness).

 

 

The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. All performance referenced is historical and is no guarantee of future results. All indices are unmanaged and may not be invested into directly.

There is no guarantee that a diversified portfolio will enhance overall returns or outperform a non-diversified portfolio. Diversification does not protect against market risk.

Investing in stocks and mutual funds involves risk, including possible loss of principal.

Investors should consider the investment objectives, risk, charges and expenses of the mutual fund carefully before investing. The prospectus contains this and other important information about the mutual fund. You can obtain the prospectus from your financial representative. Read carefully before investing.

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