How to Avoid Mutual fund overlap and maintain a Diversified Portfolio

Are you unintentionally doubling up on your investments? It’s a common pitfall that many investors fall into without even realizing it. Today, let’s dive into the concept of mutual fund portfolio overlap and how simplifying your investment portfolio can lead to better financial health.

As I mentioned in my earlier article on Complexity bias, we humans have a tendency to believe that complex solutions are always better than the simple ones. We hardly value simplicity. 

Investors often display this bias when they insist on adding more products, strategies, or layers of complexity to their Investment plans, believing that this will somehow yield better results.

In the name of diversification, investors tend to make mistakes by adding more similar kinds of products which doesn’t help in enhancing portfolio return, rather increases the cost and management load in the whole portfolio.

If you are already into this kind of soup, and now want to restructure your investment portfolio, to enhance simplicity, then this article is for you. Or if you prefer keeping your portfolio simple and avoiding any portfolio overlap…keep reading.

In this article we would discuss Mutual fund portfolio overlap.

What is Mutual fund Overlap?

Mutual fund portfolio overlap occurs when you hold multiple funds that invest in similar securities or sectors. While diversification is essential for managing risk, excessive overlap can undermine its benefits. Imagine holding several funds that all have significant allocations to the same stocks or industries. In essence, you’re not spreading your risk but instead concentrating it in a few areas.

Investors often invest in multiple mutual fund schemes under the impression of diversifying their portfolios. However, they might unknowingly invest in schemes with a significant overlap of common stocks.

So, even if you have 4 mutual fund schemes in your portfolio but all have similar stocks, then ultimately you are concentrated in those few stocks only. 

Let me show you some data.

Below table is showing the Overlap mix of different funds. 

Please note that the funds are chosen randomly and just to show you the example of Mutual funds overlap.

Why the Portfolio Overlap is bad for Investments?

Overlapping mutual funds can lead to several pitfalls:

1. Lack of True Diversification: Holding multiple funds with similar holdings doesn’t provide the diversification you might think. Instead, it exposes you to concentrated risk in those specific assets. 

If you invest in funds that heavily overlap, you might inadvertently amplify your exposure to certain stocks or sectors. Consequently, any adverse impacts on these overlapping stocks could significantly affect your portfolio. Overconcentration in specific sectors could also subject your portfolio to the cyclical fluctuations experienced by many industries.

You may find the same kind of Volatility in Returns in the funds with high overlap, and you may also limit your portfolio’s access to different other market opportunities. 

2. Duplication of Fees: Each mutual fund comes with its own set of fees and expenses. By holding overlapping funds, you’re essentially paying multiple times for similar investment strategies.

3. Complexity: Managing a portfolio with overlapping funds can be unnecessarily complicated. Tracking performance, rebalancing, and making informed decisions become more challenging when you have redundant holdings.

The above are the pitfalls when you invest without awareness. But I have seen many investors who intentionally buy similar kinds of funds by giving performance as the reason. If Small caps are performing that does not mean you have to buy all the small cap funds of the industry and even keep only small caps in the portfolio. This is a very wrong way of investing.

How to Identify and Address Mutual fund Portfolio Overlap?

So, how can you identify and address mutual fund overlap in your portfolio?

There are many online tools provided by Mutual fund research websites which will help you identify the portfolio overlap. But i am going to tell you a few steps so you yourself could find out the overlap or not to have the same in the first place.

1. Have one fund in one category of Mutual fund. – SEBI has clearly categorized the Mutual funds as per market capitalization. So while designing the portfolio, you may choose only one fund from each category. And if at all you want to add more be sure there must be a difference in the style of investment, as otherwise this will definitely lead to some portfolio overlap.

For e.g. Either you have Active large cap or Passive Large cap (Index funds), as both will have the same universe of stocks to pick. However, if you like to have both, then do have a reason for the same, which will help you review the portfolio at the regular intervals. 

Adding 2 Active large caps and 2 Passive, may only complicate the portfolio and will create unnecessary Portfolio Overlap.

2. Avoid 2 funds of the same asset from the same Mutual fund house. This sometimes may not result in a Portfolio overlap but many times a strategy and thought process overlap. Sometimes you add up 2 mutual funds being managed by the same fund manager and find both of those funds doing well or not at the same time…even if the fund categories are different. This is because of the fund house and manager’s philosophy. 

3. Better have more Passive mutual funds into the portfolio, to avoid portfolio Overlap.

Index funds or Smart Beta funds in different categories are structured to target different investing styles or market capitalization, resulting into very less overlap

4. Sometimes categories are different but SEBI definition is overlapping on different funds. Like Flexi cap funds, which has to pick the stocks from the universe of 500 stocks. And in these 500 stocks, 65-70% weightage is of large cap. Now adding such fund may feel you like having an overlapped portfolio, but still these funds have the flexibility to move between market capitalisation so you may choose one for your portfolio

5. Seek Professional Guidance: Working with a financial advisor can help you navigate mutual fund overlap and optimize your investment strategy. An advisor can provide valuable insights and recommendations tailored to your financial goals and risk tolerance.

Conclusion:

You cannot completely avoid Mutual fund portfolio Overlap. And moreover having an overlap also is not bad every time. It all depends on the stocks weights in the portfolio and the investment style different managers are working with.

For e.g Some may consider X stock as “growth”, and some as “value”, and both may have considerable allocation in the same stock. Once you have identified this are are aware of the investing styles and are fine with it, its ok having both mutual funds in the portfolio. And by the way , we are not talking about only one stock overlap.

Mutual fund overlap can sneak into your portfolio unnoticed, but it’s essential to address it proactively. By identifying and reducing overlap, you can build a stronger, more resilient investment portfolio that aligns with your financial goals. Remember, simplicity is often the key to success in personal finance.