Does mutual fund style category composition explain the benefits of family diversification? Open Access
Teodorescu, Andrew (Spring 2020)
Abstract
This study examines the influence of family and investment style category factors on the cross-sectional variance and correlation structure of actively managed U.S. mutual fund returns. I find that actively managed fund family returns are largely driven by category factors, and that cross-family correlation rises when accounting for the category composition of the families. In particular, category structure explains roughly half of the cross-sectional differences in family return volatility. Diversification across categories within the same family seems to be a better bet than diversification across families within the same category. My findings suggest that category diversification explains a considerable portion of the rise in investor risk that previous studies have identified when investments are constrained to funds within just one family.
Table of Contents
1. Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1
2. Data . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3
2.1. Sample construction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3
2.2. Category composition and return correlations . . . . . . . . . . . . . . . . . 4
3. Model and empirical design . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5
3.1. Modeling decomposition into fixed effects . . . . . . . . . . . . . . . . . . . . 5
3.2. Choosing a baseline return . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6
3.3. Components of family returns . . . . . . . . . . . . . . . . . . . . . . . . . . 7
3.4. Understanding variation in family returns . . . . . . . . . . . . . . . . . . . 8
3.5. Components of category returns . . . . . . . . . . . . . . . . . . . . . . . . . 8
3.6. Value-weighted decomposition . . . . . . . . . . . . . . . . . . . . . . . . . . 9
4. Decomposition results . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10
4.1. Role of family and category effects in return volatility . . . . . . . . . . . . . 10
4.2. Absolute family and category effects and model fit . . . . . . . . . . . . . . . 11
4.3. Decomposition corrections in family and category correlations . . . . . . . . 11
4.4. Implications for portfolio diversification . . . . . . . . . . . . . . . . . . . . . 12
5. Conclusions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 13
Appendix . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 26
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