Many investors choose to invest through the mutual fund route to make their investment experience easy and, at the same time, get broad market exposure.
However, over time, poor portfolio monitoring can lead to duplicate holdings across various funds, which minimises diversification and increases risks. This is known as mutual fund overlap and can have a dramatic influence on the performance of the portfolio in volatile times.
This article will explain mutual fund overlap and suggest strategies to mitigate it.
Mutual fund overlap is the overlapping of stocks, bonds, or securities in multiple funds. It reduces the efficiency of diversification undertaken by investors because it allocates their money to similar or near-similar funds, increasing the risk to their investments under similar circumstances. Overlapping funds pool investments in similar to near-similar holdings, creating an unintended effect, mainly during market falls.
Let's take an example – a large-cap fund. There are 34 funds in this category as of date. If you are investing in two large-cap funds, each may have significant holdings of Tata Consultancy Services or Reliance. Even though you invest in different mutual funds, they offer the same exposure, reducing diversification. This will result in a larger overlap.
Overlapping mutual funds is an important consideration for investors looking for a diversified portfolio. Portfolio overlap has the following disadvantages:
The overlap between two funds, A and B, is calculated by dividing the number of common stocks (counted twice) by the total number of unique stocks across both portfolios. This metric helps investors assess how much of their exposure to one fund is already represented in the other, indicating potential risks or redundancies. A high overlap may suggest that the funds are not sufficiently diversified, while a low overlap can imply that the funds offer distinct investment strategies.
Identifying and rectifying overlaps is very important to have an all-rounded or diversified portfolio. Here are some of the key steps to identify overlaps:
For example, Morning Star’s Portfolio X-Ray tool uses the global investment database to explore your holdings at a deeper level to identify stock overlap. It can also provide a snapshot of the diversification of your investments. If you hold mutual fund investments across several funds, such a tool can be useful to ensure adequate diversification without overlap.
Building a resilient and diversified mutual fund portfolio requires careful planning, and every investment must be made for a distinct reason. As assets periodically evolve, the overlap will also change. Here are a few pointers to implement diversification to avoid overlap:
Invest in a mix of large-cap, mid-cap, and sector-specific funds based on your goals and preferences. This strategy ensures you do not overexpose yourself to any one part of the market. You can achieve risk-adjusted returns by spreading across different fund categories. For example, add small-cap funds and big-cap holdings to spread your risk and capture all growth opportunities.
Review holdings across every mutual fund to determine the overlaps in stocks or sectors. If you have three funds that hold the same stock, such as Tata Motors, you should reconsider your allocation. Overlap in investments can be eliminated by shifting your investments. That will help in better diversification.
Review your portfolio periodically to ensure that it remains diversified. Market swings and changes in fund performance could have caused the portfolio to become imbalanced. Rebalancing from time to time will enable you to restore proper asset allocation.
Select complementary funds with unique investment strategies to avoid overlap. For example, matching a growth-based fund with a value-based fund diversifies your portfolio. This minimises the chances of holding funds targeting the same investments.
Ultimately, understanding and managing mutual fund overlap is crucial for investors. By identifying overlaps and actively managing your portfolio, you can mitigate risks and maximise returns. Regular evaluation will help your portfolio remain diversified. It will ensure that your investments align with your financial goals and enhance the general resiliency of your portfolio against market variations.