What is Mutual Fund Portfolio Overlap and How to Reduce it?
6 October 2022
A mutual fund overlap is a widespread phenomenon that most investors don’t notice, but it does help to be aware of. To diversify their portfolio, investors generally invest in two or more funds that may or may not have a common motive but may have a similar strategy or stock portfolio, which leads to overlap of securities. While it cannot be termed as a problem, being overlapped in mutual funds may defeat the purpose of diversification as an investment strategy.
Let’s first dive into what exactly this overlap is and what are some of the expected effects of the same.
What is Mutual Fund Overlap?
For diversification, we often invest in multiple mutual fund schemes or AMCs. But sometimes, these AMCs choose the same stocks as part of their fund composition, in line with the fund objectives.
When an individual invests in different mutual fund investment schemes, there may be a high chance of overlap in mutual funds. The overlap also means that the diversification they initially may have sought is no longer there. It’s a common problem, but one should always ask some common questions about mutual funds and their portfolio composition before investing. This article will answer some of your basic questions about ‘mutual fund portfolio overlap’.
How Does a Mutual Fund Overlap Work?
It usually happens when two different funds try to capture as much of the opportunity from the market through choice pickings of stocks to meet their goals of returning higher-than-benchmark results to investors.
Most fund objectives may produce similar fund compositions even if their strategy differs. Let’s have a look at an example. Imagine you’re interested in the ABC mutual fund, which has a fund composition that includes shares of the company XYZ.
You also invest in some other mutual funds companies to diversify your portfolio. But that fund, too, has invested in XYZ, the same company, as part of their overall investment strategy and that’s how the overlapping of mutual funds occurs.
A mutual fund portfolio is a testament to your collection of investments made in different schemes. All these investments are synchronized with your investment goal and objectives. Generally, it illustrates a comprehensive index of your investment in mutual funds and how you can better analyze and manage your portfolio.
A common mistake you must’ve noticed is that when you check in your portfolio, there’s overlap, or sometimes portfolios overlap mutual funds. Now, you may be investing to diversify your investment portfolio. But sometimes, you invest in purchasing the same assets. In that case, this will not serve as your objective to diversify your portfolio; hence, overlapping occurs.
What are the Effects of Mutual Fund Portfolio Overlap?
Mutual funds are a popular choice for investors, especially regarding portfolio diversification. Through a single product, the investor can gain exposure to any securities.
Although overlapping is a standard error that one may face, investors may benefit from avoiding it.
Mutual fund portfolio overlap reduces all the benefits one can get from diversification.If the stocks with the overlap perform negatively, there is a high chance that all the funds with high exposure to that stock in their portfolio will also deliver negative performance. This kind of compounds the losses for the investor.
Therefore, overlapping can sometimes lead to an increase in losses.
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Tools to Identify Mutual Fund Overlap
There are numerous ways by which you can calculate your mutual fund overlap. Some of the mutual fund overlap calculators are available on various websites. Two of them stand out are-
Advisorkhoj.com: One of the most prominent websites that act as a mutual fund overlap screener is advisorkhij.com. This website gets you to the leading portal, where mutual fund overlap can be checked. It tells you about common and uncommon stocks, their percentage holding, and almost every detail you may need while checking the overlap in mutual funds. Although there is a specific limitation to the website, you cannot compare the cross-category schemes on this website. For that, we have another website for you.
Thefundo.com: Another mutual fund overlap calculator is thefundo.com. It is also a well-known tool that investors often use. Besides that, it is relatively easy to operate. As stated before, it facilitates cross-category comparison of portfolios. It takes you to a portal where you can compare your AMCs or schemes. Moreover, it also tells you a clear analogy of your mutual fund.
How to Reduce Mutual Fund Portfolio Overlap?
1. Shuffle/ Re-consider your Schemes
Many investors keep adding new MF schemes to their portfolios for whatever reason. This could lead to overlapping mutual funds that should be avoided at all costs. Always align your objectives with the respective mutual fund and then invest.
2. Eliminate Schemes with Overlapping Investments
Holding multiple schemes with similar fund objectives increases the chance of investment in the same stocks with similar strategies. In this case, it will not add much volume to the portfolio.
For example, if you already have a large cap mutual fund in your portfolio, you may want to choose some other criteria should you need to invest in another mutual fund. Irrespective of which AMC they belong to, most large-cap funds tend to invest in the same top-performing stocks from the benchmark indices.
3. Filter Out the Underperformers
Continuous bad performance of a mutual fund scheme compared to the other categories, peers, and the benchmark index is an important benchmark that should be considered in order to eliminate the underperformers. However, note that it may be unfair to judge a mutual fund on short-term performances, while past performance may not indicate future performance.
Why is Diversification Crucial to Avoid Mutual Fund Overlap?
While diversification is essential to lessen the risk in an investment portfolio, this diversion needs to lead to mutual fund overlap. Interestingly, diversification is also the answer to avoiding mutual fund overlap.
Mutual fund diversification affects a portfolio significantly. It can give an investor higher exposure to varied securities that may or may not be correlated, capturing as many potential returns as possible. That makes it crucial to have an even diversified portfolio for the long run.
However, when diversifying across mutual funds, portfolio overlap significantly increases. As highlighted in the section above, one easy way to avoid this overlap is to take the extra measure of comparing the composition of the funds before adding them to your mutual fund portfolio.
While mutual fund overlap cannot be completely avoided, given all mutual funds pick from the same set of listed stocks available in the stock market, one can be wary of the amount of exposure each fund has to the same stocks.
Diversifying your investment portfolio with the portfolio overlap carefully charted out is the perfect strategy for maximizing your returns from the equity segment. While diversification will help you counter the market volatility, you are also benefiting from multiple fund managers’ expertise in the industry.
A minimal overlap would not harm the return rates of an investor. However, if it extends beyond a limit,l, there may be a significant effect on the return of your investments. High overlap exposes your portfolio to company-specific risk. It limits the portfolio returns when the stock is negatively impacted and does not offer much buffer during volatile times in the market, which was the point of diversification in the first place.
The very purpose of investing in multiple schemes is to diversify your portfolio and gain the maximum amount of return. It tends to lose the sole purpose if overlapping is too prominent.
Investors frequently diversify portfolios to get maximum returns at minimum risks. But one should always check for overlapping mutual funds. Mutual fund overlap directly takes you to limited diversification and thereby exposes you to higher market risks without offering a buffer against volatility.
Apart from that, it also amplifies your losses.
You need to ensure to include only those schemes in your mutual fund portfolio that align with your financial goals and personalised asset allocation plan.
Q1. How much diversification is enough in mutual funds?
Ans:Mutual funds, by nature, are various products. Each mutual fund comprises a diversified portfolio of stocks and other securities in line with the fund’s objectives. Various types of mutual funds cater to different segments, sectors, categories, strategies, risk profiles, etc. One may choose to have two to five funds in their investment portfolio that are said to be enough for diversification.
Q2. What is an ideal mutual fund portfolio?
Ans: Some experts say that a perfect portfolio has between 20 and 30 stocks for the manageability and diversification of most portfolios of individual stocks. Regarding mutual funds, they consist of a set of stocks, generally 15-20 stores each. There is no guideline here, and fund managers reserve the right to choose the ideal composition based on the fund objective and their target. A perfect mutual fund portfolio comprises two to five funds of varying investment strategies.
Q3. How much overlap is acceptable?
Ans: Investors can invest 15% in small caps and 30% in large caps (remember that small caps mean higher risks) based on their risk appetite. So the resulting overlap could be approximately 40%. The point should be that these numbers are subject to change.
Q4. How do you stop the mutual funds from overlapping?
Ans: Go through your mutual fund portfolio carefully. Look for exposure to specific stocks. Check for the overlap in large and multi-cap. Use a statistical tool to identify it. While you cannot wholly avoid mutual fund overlap, you can work on keeping it within minimal limits by choosing funds with varying strategies and approaches to investing.
Q5. How long should you hold a mutual fund?
Ans: Well, it depends on your objectives and your long or short-term goals. But talking specifically about long-term goals, it can go well beyond ten years!. Apart from this, it also depends on the type of fund in which you have invested. Most funds tend to return well over the longer term, aided by the power of compounding. A SIP for a long time is the perfect strategy to create wealth over the long term.
Before you go…
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Disclaimer: Mutual Fund investments are subject to market risks, read all scheme-related documents carefully.
This article has been prepared on the basis of internal data, publicly available information and other sources believed to be reliable. The information contained in this article is for general purposes only and not a complete disclosure of every material fact. It should not be construed as investment advice to any party. The article does not warrant the completeness or accuracy of the information and disclaims all liabilities, losses and damages arising out of the use of this information. Readers shall be fully liable/responsible for any decision taken on the basis of this article.
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