The Impact of COVID-19 on Portfolio Diversification: Evidence from U.S. Equity Mutual Funds

Abstract

Previous academic literature highlights that an optimal point exists at which further diversification leads to diminishing returns, a concept often referred to as 'diworsification'. Furthermore, while numerous studies explore the influence of market conditions on optimal portfolio diversification; a significant gap in the literature regarding the specific impact of the COVID-19 crisis remains. During the COVID-19 pandemic, financial markets experienced a significant decline impacting diversification benefits for mutual funds. Therefore, this study examines optimal portfolio diversification during the COVID-19 pandemic with a focus on U.S. equity mutual funds. We conduct an empirical framework that examines the relationship between the Sharpe ratio and the optimal number of stocks using Fixed Effects (FE) regression analyses with quarterly intervals from the third quarter of 2016 to the second quarter of 2023. In particular, this study focuses on the difference between the COVID-19 period and the non-COVID-19 period by including binary interaction terms. Results show that the optimum number of stocks for U.S. equity mutual funds is approximately 265-285 during the sample period and approximately 15 stocks higher during the COVID-19 period compared to the non-COVID-19 period. Hence, our results show that U.S. equity mutual fund managers should increase their stock holdings when an economic crisis is present to maintain higher risk-adjusted returns. In addition, investors who invest in mutual equity funds benefit from understanding optimal investment allocations.