The Diversification Factor in Mutual Fund Returns
27 Pages Posted: 18 Aug 2017
Date Written: August 18, 2017
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
Suggested Citation: Suggested Citation