Last Updated on Dec 13, 2022 by
A portfolio refers to the collection of various investment holdings of an individual. When it comes to mutual funds, an individual can own many: debt, equity, small-cap, etc. Your entire mutual fund holdings list is referred to as your mutual fund portfolio. However, if you invest in multiple funds that invest in similar instruments, your portfolio will end up having an overlap, which is known as mutual fund overlap. In this article, let us understand what mutual funds overlap is, how to check and avoid it.
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What is mutual fund overlap?
If you invest your savings in multiple mutual funds which have the same holdings/asset allocation, it can result in mutual fund overlap. This defies your objective of diversifying the portfolio and makes you prone to market risk. To diversify your portfolio, you should invest in different mutual funds managed by different asset management companies.
For example, let us say that you, as an investor, invest in AB’s small-cap mutual fund. After some time, you see XY’s small-cap mutual fund is giving more returns, and then you start a SIP in XY’s mutual fund. In this scenario, both AB and XY mutual fund portfolio holdings are similar. That is, they both invest in the same companies. This is termed fund overlapping.
How does mutual fund overlap work?
If two different funds try to achieve the same goal, they might overlap each other. For instance, the Exchange Traded Fund (ETF) of two different AMCs will replicate the index to give similar returns. In that case, you will not want to invest your capital in the same fund where the degree of overlapping is high.
Sometimes, at the time of your investment, the two small-cap funds could be investing in different companies, but with time, their holdings start replicating each other. It is also possible that the fund will shift its goal. This behaviour is also called style drift.
Changing managers may also lead to the overlapping of funds. Therefore, the best solution is constantly monitoring your portfolio and fund components. This will keep you informed if your funds are overlapping, so you can take corrective action accordingly.
What are the difficulties with mutual fund portfolio overlap?
- Diversification goal is not achieved
The main motive of mutual funds is to diversify the portfolio and hedge the risk against market instabilities. Overlapping of funds goes against that motive; in fact, a fund overlap maximises stock market-related risk.
For instance, investors with more direct exposure to the equity segment should invest in debt mutual funds or gold exchange-traded funds to hedge the risk against a market crash. The two usually show a negative correlation; if the stock market crashes, the chances of gold prices rising are high. Thus, this diversification of the portfolio will help save capital from erosion.
- Needs unnecessary monitoring
If the mutual fund portfolio is overlapping, then you will have to spend more time monitoring mutual fund investments. Therefore, redeeming one of your funds is recommended if your overlap is higher than 10%.
How are returns affected by overlapping?
One of the biggest reasons investors prefer mutual funds is because they are inherently diversified. Thus, when funds are allocated in the same sector/companies, diversification benefits can sometimes be offset. In such a case, if the pharma sector is not doing well, both of your funds that invest in pharma will perform poorly. However, this can benefit you well if the pharma sector is doing well.
Despite this, experienced investors are encouraged to find investments with negative correlations so as to hedge against market risk.
How do you reduce the overlapping of your mutual fund investment?
Generally, you invest in mutual funds to diversify your portfolio and protect your money from various market-related risks. Therefore, if your investment products or companies overlap, the motive of diversification fails. Thus, to reduce overlapping, you need to understand the different types of mutual funds so you can make informed decisions.
- Debt funds: These allocate the pooled money into money market instruments to earn a fixed income. The fund allocation into the money market reduces the risk of investment and diversifies investors’ portfolios into risk-free asset classes.
- Equity funds: These are the riskiest types of mutual funds as the allocation of funds is primarily in equity markets. However, to compensate for the risk, they offer higher returns as compared to debt funds. Equity funds can also be sub-categorized into small-cap, mid-cap, and large-cap funds.
- Balanced/hybrid funds: These funds invest in both debt and equity. Therefore, the risk of investing in hybrid funds is lower than in equity funds but higher than in debt funds.
Technology has made it even more convenient to avoid overlapping your portfolio. Various aggregator websites are available today where you just have to input the name of a scheme, and the website will show you other funds with the same portfolio holdings.
How to avoid mutual fund overlap?
Many investors tend to invest in new mutual fund schemes; avoiding overlapping may not be easy. Hence before investing, plan your goals first. Once these match the fund’s goals, then analyse the fundamentals of the fund. But when you have multiple schemes matching your goals, you may invest in the same stocks, but it won’t add much value to your portfolio.
For example, if you have a large-cap fund in your portfolio, pick some other parameter, as many companies tend to invest in the same large-cap companies that perform the best.
How to redeem a mutual fund?
This is the most common question that arises among mutual fund investors. Here are some ways to redeem a mutual fund.
If your investment type is direct, you can redeem the mutual funds directly through Asset Management Companies (AMC) website. The units of your mutual funds can be sold directly on the website. Once the redemption is accepted, and the mutual fund units are sold, the proceeds are directly deposited into your account.
You can sell units directly on the platform if you have invested in mutual funds via a trading or Demat account. After the units are sold, the proceeds are transferred back into your Demat account, which you can credit into the bank account.
However, if you invested in mutual funds via different agents or distributors, you can redeem the fund online on their websites or mobile applications. The proceeds are then transferred into your bank account via NEFT or RTGS.
Does looking for different managers work?
The investment goal and style of investment of the majority of fund managers are the same. The philosophy behind making money is the same when the financial objective is similar; therefore, the stock selection might be the same as well.
Therefore, diversifying and selecting different fund managers can also help an investor to avoid fund overlap. Also, avoid investing in too many funds from the same manager.
The Indian stock market only has 7,462 listed companies. Therefore, it is impossible not to have an overlapping portfolio.
For example, a bluechip equity fund will have the top IT companies, and an IT fund will also have top-level IT companies. However, what matters is the percentage of the overlap. It is your responsibility as a smart investor to manage this overlap, so your capital remains truly diversified and is hedged against market volatility.
1. Why is diversification important for a mutual fund portfolio?
‘Don’t put all your eggs in one basket’, this explains the importance of portfolio diversification better. Diversifying your portfolio can help you avoid investment risks. Though it does not guarantee that losses won’t occur, there are chances it will reduce the losses. If you invest in different assets, even if one asset is at a loss, it won’t hurt your investment much.
2. Is mutual fund portfolio overlap bad?
One of the reasons to invest in mutual funds is to have a diversified investment portfolio. And when you invest your money in the same sector or company twice, imagine if the sector or company is in loss; your investment in both funds can experience a loss. However, it can be a positive sign if the sector/company is performing well. But to avoid the loss, it is better to avoid mutual funds overlap.