Mutual Fund Portfolio Overlap: Meaning and How to Avoid It

Investing in mutual funds is a common and effective way to build a diversified portfolio. Portfolio overlap occurs when multiple mutual funds hold significant positions in the same securities, leading to redundancy and potentially undermining the benefits of diversification.

This blog post by Shriram AMC delves into the concept of mutual fund portfolio overlap, exploring its causes, the importance of avoiding it, and practical steps to identify and reduce it. By gaining a clear understanding of portfolio overlap, investors can enhance their portfolio's diversification, manage risks more effectively, and achieve better long-term financial outcomes.

Mutual Funds Overlap: What is It?

Mutual fund portfolio overlap occurs when multiple mutual funds within an investor’s portfolio hold the same or similar securities. While diversification is a key reason for investing in mutual funds, portfolio overlap can undermine this goal by reducing the benefits of diversification.

Imagine you have invested in two different mutual funds, each managed by separate financial institutions. If both funds hold significant shares of the same companies, your overall investment portfolio becomes less diversified than you might think. This overlap means that if those shared stocks perform poorly, both funds will be negatively impacted, affecting your portfolio's overall performance.

Why Does Mutual Fund Portfolio Overlap Happen?

Portfolio overlap happens for several reasons, often arising from how mutual funds are structured and managed:
 

Similar Investment Mandates

• Category-Wise Mandates: SEBI imposes category-wise mandates on mutual funds, restricting their investment universe. For instance, large-cap funds must primarily invest in the top 100 companies by market capitalization. This narrower investment universe increases the chances of overlap among different funds within the same category.
• Fund Manager's Style: Even within the same category, fund managers may have similar investment styles or biases, leading to overlap in their stock selections.

 

Market Trends and Popular Stocks

• Sectoral Trends: When certain sectors or industries are performing well, multiple funds may invest in the same stocks, leading to overlap.
• Popular Stocks: High-quality, well-known stocks are often favored by multiple fund managers, further contributing to overlap.

 

AMC-Specific Investment Style

• Asset management companies (AMCs) often have a unique investment philosophy and approach. This can lead to an overlap among funds managed by the same AMC, even if they belong to different categories.

Why is Diversification Crucial to Avoid Mutual Fund Overlap?

Diversification is a fundamental principle of investing, aiming to spread risk across various assets to reduce the impact of any single investment’s poor performance. Here is why diversification is crucial:

• Risk Management: Proper diversification ensures that the failure of one investment does not disproportionately affect your entire portfolio.
• Stability: A diversified portfolio is generally more stable, as the positive performance of some investments can offset the negative performance of others.
• Growth Opportunities: By investing in a range of asset classes and sectors, you may take advantage of potential growth opportunities across different areas of the market.

How to Identify Portfolio Overlap Within Mutual Funds

Identifying portfolio overlap requires examining the holdings of the mutual funds in your portfolio. Here are steps to help you:

• Review Fund Holdings: Most mutual funds publish their holdings periodically. Review these reports to see which securities are held by each fund.
• Use Online Tools: Several online tools and platforms can analyse your portfolio for overlap. These tools compare the holdings of different funds and highlight overlaps.
• Consult with a Financial Advisor: A financial advisor can provide a detailed analysis of your portfolio and identify any significant overlaps.

How Can You Reduce Portfolio Overlap in Your Holdings?

Reducing portfolio overlap involves strategic adjustments to ensure better diversification. Here are some practical steps:

• Choose Distinct Funds: Select mutual funds with different investment strategies, sectors, or geographical focuses. This approach reduces the likelihood of overlap.
• Use Index Funds and ETFs: Consider incorporating index funds and exchange-traded funds (ETFs) that track different indices. These funds often have less overlap compared to actively managed funds.
• Diversify by Asset Class: Include a mix of asset classes (stocks, bonds, real estate, etc.) in your portfolio. This broad diversification further reduces the impact of any one investment’s performance.
• Regular Portfolio Review: Review and rebalance your portfolio to ensure it remains aligned with your diversification goals. Selling off overlapping investments and reinvesting in distinct assets can help maintain balance.

Advantages of Avoiding Portfolio Overlap

Avoiding portfolio overlap has several advantages. Some of them are:

• Enhanced Diversification: Ensures your investments are spread across a broader range of assets, sectors, and geographies, reducing risk.
• Optimised Performance: A well-diversified portfolio can potentially provide more stable and consistent returns over time.
• Improved Risk Management: Reduces the impact of poor performance in any single investment, protecting your overall portfolio.
• Better Resource Allocation: This allows you to allocate resources more effectively, ensuring that each investment contributes uniquely to your portfolio’s growth.

Conclusion

Understanding mutual fund portfolio overlap is crucial for investors looking to build a well-diversified investment portfolio. By recognising why overlap occurs, the importance of diversification, methods to identify overlap, and strategies to reduce it, investors can make informed decisions to optimise their investment outcomes.

Avoiding portfolio overlap not only enhances diversification but also reduces risk and potentially improves long-term investment performance. For a robust investment strategy, prioritising diversification while managing overlap remains key to achieving financial goals.

FAQs

Here are a few FAQs that help investors understand mutual fund overlap:

1. What is mutual fund overlap?

Mutual fund overlap occurs when two or more funds hold similar stocks or assets, leading to redundant exposure in your portfolio.
 

2. How can you check mutual fund overlap?

Review the top holdings of each fund in your portfolio and compare them to identify any repeated assets or stocks.
 

3. What are the risks of mutual fund overlap?

Overlap increases exposure to the same market risks, reducing diversification and potentially magnifying losses if common holdings underperform.
 

4. How can you reduce mutual fund overlap?

Choose funds with different investment strategies, sectors, or geographic focuses to ensure broader diversification and minimise overlap.
 

5. Is mutual fund overlap always bad?

Not always, but excessive overlap can negate diversification benefits, leading to higher risk and less effective investment strategies. Balance is key