Recent studies have shown that the more a mutual fund differs from its benchmark, the stronger its performance is. Two standard ways of examining how mutual funds differ from their benchmarks are (1) looking at “active share” and (2) ranking funds by their correlation with their benchmark or R² (from an ordinary least-squares regression). The authors use R² for this study. This research is different from past research in that the authors study the benefits of diversifying among low R² funds. They are essentially testing the principle of modern portfolio theory that states that the idiosyncratic risk of individual securities can be eliminated through diversification.

The benefits of diversifying a stock portfolio have been well documented. By spreading out individual company or idiosyncratic risk, investors can enjoy the returns of their portfolio while lowering the standard deviation. The authors take this concept one step further by applying it to mutual funds. Specifically, they are analyzing mutual funds that deviate from their respective benchmarks through active management. Studies have shown that these funds have outperformed the benchmarks as well as the universe of all active funds. The authors find that by diversifying among low R² funds, investors can continue to achieve outperformance while lowering the volatility of the portfolios. Most of the benefits come from diversifying in as few as 10 different funds, although the authors examine diversifying in up to 200 funds.

The authors use Morningstar Direct to examine all open equity mutual funds that are classified as the broad asset class of “US stock.” The time period of the study is December 1995–March 2013 (data are collected on a monthly basis). They look only at funds labeled “active” and exclude index or enhanced index funds. They then segment the funds into quintiles based on the R² from a regression on four factors for the previous 24 months and examine the benefits of diversifying the quintiles of funds from 1 fund to 200 funds. Rebalancing occurs on a monthly basis and also on a more practical annual basis.

Volatility is significantly reduced among the lowest-quintile R² funds compared with an “all active funds” portfolio when diversifying from 1 to 10 funds; even better results occur when they use more than 50 funds. The benefits of diversification grow as R² decreases. The authors also examine shortfall risk as opposed to standard deviation and find that the lowest-quintile R² funds outperform the “all active funds” portfolio as well as the “all passive funds” portfolio. Consequently, a diversified basket of lower R² funds generates higher return with lower shortfall risk.

Investors and their advisers would find this information useful because diversifying with weakly correlated funds proves to be much more beneficial than doing so with highly correlated funds. A large and growing debate within investment management is on the benefits of active versus passive management. Investing in weakly correlated mutual funds versus the respective benchmarks falls into the active camp. This research would be particularly useful for investors and advisers who use active management in mutual funds. A commonly held belief is that having a diversified mutual fund lowers idiosyncratic risk. But this research reveals that investors can benefit from further diversification by choosing weakly correlated mutual funds and doing so with as few as 10 funds.