The Sources of Portfolio Volatility and Mutual Fund Performance

Abstract

We conduct a volatility decomposition to identify the source of performance differences between low volatility and high volatility mutual funds. Our procedure demonstrates how security-level variances and covariances lead to idiosyncratic volatility effects at the portfolio level. We show that a measure constructed from the average covariances of securities in a fund’s portfolio is sufficient to characterize the portfolio-level idiosyncratic volatility effect. In contrast, the security-level variances of funds’ holdings are only weakly associated with the idiosyncratic volatility effect but are closely tied to a fund’s exposure to the beta anomaly.

Keywords: Mutual funds, return volatility, fund manager skill, beta anomaly, return covariance