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1. Screening Funds: It's important to select funds with very similar attributes, which, in turn, will enhance the collinearity of the portfolio. In selecting the above funds, the following set of criteria has been used: NAV > $7B; Morningstar Rating = 4 to 5; Track > 10 years; Yield = Positive; YTD Return > 8%.
2. Balanced Funds: Balanced Mutual Funds are inherently diversified (40-60% in stable/dividend stocks, 30-40% in fixed incomes, and balance in Cash, Precious metals, and other debt instruments). Since these funds are self-hedged by design, meaning stocks hedged by bonds, etc., no additional hedge component is needed.
3. Fund of Funds: Creating a statistically significant Fund of Funds from a group of Balanced Mutual Funds requires that they are drawn from a highly correlated group, as shown in the correlation matrix above. Thus, while reducing the number of funds, the "least" collinearity must be adhered to. For instance, since Dodge and Cox show lower collinearity than its peers, it must be removed first from this line-up.
4. Risk Mitigation: A Fund of Funds is more prudent from the investment point of view. It helps reduce the general risk embedded in a single balanced fund (risk scenarios: merger, change of ownership, departure of a veteran portfolio manager, etc.).
Therefore, instead of investing $100K in one balanced fund, it's better to spread the sum over a group of highly correlated balanced funds (again, the highly correlated funds tend to project very similar attributes).
Disclaimer - The author does not advocate any of the funds listed here; instead, this is promoted as alternative research in creating a statistical fund of funds. Consult your Registered Rep, RIA, or Financial Planner for an appropriate asset allocation model and the suitability of mutual funds and other instruments.
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