R2 and the Benefits of Multiple-Fund Portfolios

Recent research shows superior performance of equity mutual funds which differ the most from their benchmarks. However, existing studies have not examined important questions about risk, such as the impact of holding a portfolio of low R2 funds on the reduction in portfolio risk achieved through diversifying across funds. Our study provides some answers. Using a variety of risk metrics, we evaluate the benefits of diversification among both monthly and annually reconstituted portfolios, where funds are sorted into portfolios based on their quintile rank of R2. We find that the benefits of diversification are most pronounced within a portfolio of low R2 funds, and that the benefits are increasing in the length of the reconstitution period