The Diversification Factor in Mutual Fund Returns

Abstract

Active portfolios can be more concentrated or more diversified than the market portfolio. In the latter case, the result is likely to be a tilt toward equal weights, which would impact portfolio returns in a systematic manner. To capture this tilt, we construct a simple diversification factor as the difference between returns on equal weighted and value weighted portfolios for the relevant universe. Our diversification factor accounts for up to one-half of the otherwise unexplained variation in active mutual funds’ returns. We therefore argue that the diversification factor should be used in performance evaluation of broad market equity portfolios.

Keywords: mutual funds, factor models, diversification return

JEL Classification: G11, G23