Journal of Applied Finance & Banking

In Search of Optimal Number of Bond Funds

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• Abstract

  Although bonds are less volatile than equities and the median bond fund holds about 200 bonds, bond investors still need to hold more than one bond fund to realize the optimal benefit of diversification. The simulation results show that three to five bond funds reduce standard deviation of terminal wealth by 50% and about 100 funds reduce the standard deviation by 90%. Given the annualized marginal cost of 0.13% for bond funds, bond investors should hold three to five funds. However, equity investors who want to diversify need only one to two bond funds, regardless of risk measures. Holding more than two bond funds does not reduce portfolio risk much further especially for portfolios with high equity weights. The portfolios mixed with government and corporate bond funds require even fewer funds than the portfolios mixed with high yield bond funds. These results are robust to different investment strategies, holding periods and time periods and not subject to survivorship bias. These findings can be generalized to portfolios with other asset mixes.