The Effect of Diversification on Tail Risk: Evidence from US Equity Mutual Fund Portfolios

• Date: 01 September 2016
• Published date: 01 September 2016
• DOI: http://doi.org/10.1111/irfi.12080
• Author: Inchang Hwang,Francis In,Simon Xu

The Effect of Diversification on Tail

Risk: Evidence from US Equity

Mutual Fund Portfolios

SIMON XU

†

,INCHANG HWANG

‡

AND FRANCIS IN

†

†

Department of Banking and Finance, Monash University, Clayton, VIC, Australia and

‡

Korea Insurance Research Institute, Seoul, South Korea

ABSTRACT

This paper examinesthe effect of diversification on the tail risk of US equitymu-

tual fund portfolios by utilizing classical higher-moment measures and robust

tail weight measures. Empirical results show that market standard portfolios

based on the mean-variance framework are exposed to greater tail risk than

benchmark portfolios areand diversification further intensifies this exposure.

JEL Codes: G11

I. INTRODUCTION

Research conducted in the mean-variance framework has long shown that diver-

sification offers the benefit of reducing unsystematic risk. However, a substantial

body of recent literature has shown that tail risk is not only priced in the cross-

section of stock returns but it also has strong predictive powers for aggregate

stock market returns (e.g., Bali et al. 2014; Bollerslev and Todorov 2011; Huang

et al. 2012; Kelly and Jiang 2014). These findings raise questions on the relation

between diversification and portfolio tail risk. Surprisingly, there has been rela-

tively little research in this area. Our paper fills this gap by examining the effects

of diversification on the tail risk of US mutual fund portfolios by adopting classi-

cal higher-moment measures and robust tail weight measures. We investigate the

tail risk of fund portfolios with respect to the number of underlying funds, which

is a simple and intuitive indicator of diversification.

Our focus on portfolios consisting of mutual funds is not coincidental but is

motivated by the fact that the assets under management of the mutual fund in-

dustry are larger than any other delegated asset classes. For an investor with lim-

ited capital, very large transaction costs are required to obtain a certain degree of

diversification. Thus, for small investors, mutual funds represent a reasonable al-

ternative to direct purchase in individual stocks. Previous studies have shown

that diversification decreases portfolio skewness and kurtosis (e.g., Aggarwal

and Aggarwal 1993; Hueng and Yau 2006; Simkowitz and Beedles 1978). Studies

© 2016 International Review of Finance Ltd. 2016

International Review of Finance, 16:3, 2016: pp. 483–495

DOI: 10.1111/irfi.12080