Mutual funds have become a popular investment option for many people today. By investing in mutual funds, you get the benefit of professional management and diversification across various assets. However, when you invest in multiple mutual funds, there is a chance that some of your funds may end up investing in the same securities leading to an issue called “overlap”.
In this article, we will understand what exactly mutual fund overlap means, what causes it, its implications, and how you can avoid overlap in your mutual fund portfolio.
What is Mutual Fund Overlap?
Mutual fund overlap refers to a situation where two or more mutual funds in your investment portfolio invest in the same underlying stocks, bonds or other securities.
For example, suppose you invest in two large cap mutual funds – Fund A and Fund B. You notice that both funds have allocated a significant portion to companies like Reliance, HDFC Bank and TCS. This means your investment is overlapping between these two funds when it comes to stocks like Reliance, HDFC Bank, etc.
In other words, the securities picked by the fund managers are the same across both funds, leading to an overlapping investment allocation. This overlap tends to occur more when you invest in multiple funds from the same category such as large cap, mid cap, sectoral, etc.
Why Does Mutual Fund Overlap Occur?
There are a few key reasons why mutual fund overlap occurs in many investor portfolios:
Similar Investing Strategies
Fund managers of the same category tend to employ similar investing approaches. For example, large cap fund managers would favor large, established companies for stability and hence end up picking stocks like Reliance, TCS, Infosys which are in most large cap fund portfolios.
Popular Stocks
Certain stocks like the FAANG stocks are hugely popular and widely held across fund houses. So tech focused funds or even large cap funds in general hold these stocks leading to overlap.
Index Funds
Index funds that track the same benchmarks like Nifty 50 or Sensex will end up having almost the same collection of securities that the index comprises. So their portfolios overlap significantly.
As you diversify across more mutual funds, the likelihood of overlapping allocations goes up due to these reasons.
Implications of Mutual Fund Overlap
What happens when mutual funds overlap their investments across your portfolio? Here are some implications:
Reduced Diversification
The very purpose of investing across multiple mutual funds gets defeated if the funds pick the same stocks. Overlap results in reduced diversification since your money ends up getting concentrated in fewer assets.
Overexposure to Certain Assets
Suppose 5 of your funds buy Infosys shares. This results in a disproportionate allocation towards Infosys across your portfolio, exposing you to higher risk if Infosys underperforms.
Amplified Losses
If the overlapping assets between your funds perform poorly, they will drag down the returns of multiple funds in your portfolio leading to amplified losses. The diversification benefit is lost.
So it’s clear that mutual fund overlap dilutes the core benefit of diversification that investors aim to achieve via investing across multiple funds. It increases portfolio risk if overlapping assets underperform.
How to Avoid Mutual Fund Overlap
Here are some tips to avoid the problem of mutual fund overlap in your portfolio:
Analyze Fund Portfolios
Go through the latest factsheets of your mutual funds to see which stocks feature in the top 10 holdings of each fund. This will give you an indication if your funds are investing in the same stocks.
Choose Funds with Different Strategies
Don’t invest in multiple funds that employ similar strategies or invest in the same market caps, sectors, industries etc. For instance, invest in a banking sector fund and a pharmaceutical sector fund rather than two banking sector funds.
Limit Overall Funds
Try to limit your mutual fund portfolio to 4-5 funds across categories like large cap, mid cap, sector, debt, etc. Holding too many funds increases overlap.
Track Over Time
Fund portfolios are dynamic and change over time. So you have to monitor your funds regularly to check if overlap creeps in due to changes in fund holdings.
Mutual fund overlap is when two or more funds hold the same securities, reducing diversification. It occurs due to similarity in fund strategies, popularity of stocks, and index tracking. Overlap can amplify losses and undermine your investment rationale. So analyze your portfolio, limit overall funds, and keep tracking overlap periodically. Avoiding overlap is crucial to reap the benefits of mutual fund investing.