Diversified Portfolio Ups Returns Study Shows Six Mutual Funds Will Outperform One Over Time

Mutual funds function well as a convenient way to diversify your money within a type of invest ment, such as U.S. stocks or bonds, and thereby reduce volatility.

But, increasingly, investors in actively managed funds seem drawn to diversify further by spreading their dollars among many funds, even several funds with identical investment objectives.

At first glance, the logic of owning many funds, particularly many funds in the same general investment category, seems unconvincing. Most mutual funds offer more than enough diversification to offset most, if not all, of a potential collapse by one or two holdings in the fund.

“Why would anyone want 10 or 15 equity funds?” asked Catherine Voss Sanders, a senior editor at Chicago-based Morningstar, a mutual fund research firm.

Sanders and Edward O’Neal, assistant professor of finance at the University of New Hampshire at Durham, independently have been studying the multiple-fund question and finding an important answer: Investors with a dozen U.S. growth stock funds may not simply be engaging in conspicuous consumption.

Investors diversify their funds to reduce risk. But what is risk? Sanders and O’Neal believe there are at least two kinds of risk.

The risk most frequently discussed is the continuous volatility of returns - the pattern of gains and losses over time, often compared to a market benchmark. A riskier fund has a greater dispersion of gains and losses (or, in some analyses, just losses) than the benchmark.

This measure of risk, which O’Neal calls “time series” risk, relates, as investment advisers often say, to your ability to sleep comfortably with your investments day by day, or rather night by night.

But if you are a goal-oriented investor - saving for a child’s education or for retirement - your chief worry might be attaining your intended target at the end of a discrete period, which O’Neal calls “terminal wealth.”

It turns out that risk is different, depending on whether your goal is stated as a perpetuity - an endowment - or as a dollar target for some point in the future - college costs many years hence.

In an article in the Financial Analysts Journal O’Neal demonstrated that mutual fund investors stand a better chance of achieving a terminal wealth goal by owning more than one mutual fund. The more aggressive the investment program, the more funds should be held, he found.

Looking at 103 equity growth funds from 1980 through 1994, O’Neal found the average terminal wealth of $1 invested in any one fund was $14.39 after 19 years. But the range of results varied from a high of $22.82 to a low of $5.96.

On the other hand, owning six funds on average produced $13.43 at the end of 19 years. But the range was $16.05 to $10.81.

In other words, you miss the highs, but you also miss the lows.