Mutual Fund Overlap - Meaning & Risks

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. 

What is Mutual Fund Overlap?

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. 

Risks of Mutual Fund Overlap

Overlapping mutual funds is an important consideration for investors looking for a diversified portfolio. Portfolio overlap has the following disadvantages:

• Reduced Diversification: Mutual fund overlap can significantly reduce an investor's exposure to various asset classes or sectors. 
• Higher Risk: Overlapping investments often translate to higher risk due to the concentration of positions in specific stocks or sectors. The portfolio would thus increase its risk profile as it would be more prone to volatility. 
• Reduced Gains: An investor may miss opportunities for improved gains from a better-diversified portfolio by holding multiple similar funds. As a result, returns become lower than expected because of a lack of exposure to different growth opportunities.
• Higher Expenses: Holding similar or near-similar funds means paying unnecessary management fees. These extra fees eat into overall returns from the investments. 

How to Detect Mutual Fund Overlap?

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:

• Balanced Fund Comparison - Start by comparing the holdings of each mutual fund in your portfolio. Identify duplicate stocks or sectors. For example, if you hold an IT sector fund and a multi-cap fund, both might contain shares of TCS. This might lead to portfolio overlap because your exposure to other sectors will decrease.
• Review fund reports - Review fund reports and see which of the top 10 holdings are the same across multiple funds. If any of your funds hold major stocks, such as HDFC Bank or Infosys, you may have many of these investments in high concentrations.
• Use Analysis Tools - Various tools enable easy detection of overlaps through portfolio analysis. These include identifying overlapping stocks or sectors so that you can diversify your investment into other sectors. You have a huge overlap if 40% of Fund A's stocks also exist in Fund B. Several mutual fund investment platforms offer analytic tools to help investors diversify across different funds. 

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. 

• Seek Advice from Financial Experts - Financial advisors help point out overlaps and alternatives. They might suggest funds in different asset classes or sectors so you can balance your portfolio. For example, if you are too exposed to Indian equities, they may recommend international funds for diversification.

How to Avoid Overlap of Mutual Funds?

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: 

• Diversify across different types of funds

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 Fund Holdings

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. 

• Rebalance Your Portfolio Periodically

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 Funds Based on Unique Investment Strategies

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. 

Conclusion

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.