Effect of Portfolio Diversification on the Financial Performance of Listed Investment Firms in East Africa: a Comparative Analysis Across the Pre-, During, and Post Covid-19 Period

Abstract

Financial markets respond to market forces, economic factors and unexpected events, which makes risk management crucial. Diversification comes into play to reduce individual security risk and minimize market fluctuations. However, financial distress, characterized by increased market volatility and systemic risks, can pose unique challenges to traditional risk management practices, as exemplified by the Covid-19 pandemic which exposed vulnerabilities in the global market. This study delved into uncovering the extent to which profitability of investment companies trading in the various exchanges in East Africa, focusing on Kenya, Uganda, and Tanzania, from 2018 to 2022, can be tied to portfolio diversification. Data from eight listed investment firms informed the study, utilizing descriptive and causal research designs to study the influence of fund size, GDP, portfolio diversification, and the pandemic on financial performance, employing STATA 15 for analysis. In Kenya, findings indicated that fund size, GDP, portfolio diversification, and the pandemic jointly clarified 22.31% of variations in financial performance. Notably, fund size negatively but significantly affected performance, while GDP and portfolio diversification had a negative but insignificant impact. Uganda painted a brighter picture, where fund size and portfolio diversification positively impacted performance, despite GDP and the pandemic negatively affecting it. The independent variables explained 100% of variations in financial performance. In Tanzania, GDP (insignificantly) and the pandemic (significantly) exhibited a positive influence, while fund size (insignificantly) and portfolio diversification (significantly) negatively affected performance. In this market, the independent variables explained 77.25% of variations in financial performance. The study's interaction term unveiled the pandemic's impact on diversification dynamics, with unique outcomes in each country. These results emphasized opportunities for firms to explore geographical diversification in addition to asset class diversification, and advocates for regulatory requirements for stress testing of portfolios to uncover vulnerabilities in various pandemic scenarios. Further recommendations point to a mandate enforced by regulators probing investment firms to maintain a minimum level of portfolio diversification. The study paves the way for future research, exploring diversification in alternative investments and digital assets and how these influence traditional portfolios, while delving into behavioral factors that sway investor sentiments during the pandemic. Ultimately, this study offers practical insights into navigating the intricate interplay between portfolio diversification and financial health in East Africa, aiding firms and regulators in fostering a robust financial landscape.