Effect of Investment Diversification on Financial Performance of Money Market Funds in Kenya

Abstract

The financial performance of money market funds plays a critical role in enhancing financial stability and investor returns, particularly in emerging markets like Kenya. As market volatility and economic uncertainties continue to rise, the need for effective investment strategies such as diversification has become more important. This study was motivated by the growing significance of investment diversification in optimizing returns while minimizing risk. The primary objective of the study was to determine the effect of investment diversification on the financial performance of money market funds in Kenya. The study was anchored on modern portfolio theory. The study was also supported by agency theory and Capital Asset Pricing Model. The study adopted a descriptive panel research design to analyze the relationship between investment diversification and financial performance, using secondary data from 22 money market funds in Kenya over the period 2019 to 2023. Financial performance was measured by return on assets, while investment diversification was quantified using the Herfindahl-Hirschman Index. Control variables included fund liquidity, fund size, interest rate, and managerial efficiency. Data were analyzed using correlation and regression analyses, with diagnostic tests ensuring the validity of the statistical assumptions. The regression analysis revealed that the model explained 57.51% of the variance in financial performance, indicating that the independent variables provided a substantial explanation for the financial performance of the funds. Investment diversification had a positive and significant effect on financial performance (β = 0.42636, p = 0.009), confirming that more diversified funds tend to achieve higher returns. Fund liquidity (β = 1.0699, p = 0.003), fund size (β = 0.341096, p = 0.004), and interest rate (β = 1.027967, p = 0.000) also had significant positive effects on financial performance, highlighting the importance of liquidity, size, and favorable interest rates in enhancing fund performance. However, managerial efficiency did not show a significant relationship with financial performance (β = 0.77486, p = 0.670). The study concludes that investment diversification is a critical determinant of financial performance for money market funds in Kenya, in line with the principles of MPT. Fund liquidity and size are also essential in enhancing performance, while interest rates have a strong influence on returns. The lack of significance in managerial efficiency suggests that other factors, such as market conditions, may play a more dominant role in determining fund outcomes. Based on these findings, the study recommends that fund managers prioritize diversification and liquidity management strategies, as well as scale-up fund sizes to enhance returns. Policymakers should focus on creating a stable interest rate environment to support money market funds' performance. Further research is suggested to explore additional external factors such as market regulations, political stability, and investor behavior that may influence the financial performance of money market funds. Additionally, expanding the scope to include other types of mutual funds and extending the study timeframe could provide a more comprehensive understanding of diversification strategies in different financial contexts.