Here is How You Can Prevent Mutual Fund Overlap

What is mutual fund portfolio overlap and why it should be avoided?

While diversification is the basic tenet of investing, over-diversification may affect your portfolio returns. Preventing mutual fund overlap is an efficient way to achieve optimal diversification.

As you may be aware, mutual funds aim to achieve diversification by investing in a range of securities. But when one invests in multiple schemes, it can inadvertently lead to overlapping holdings (i.e. duplication of securities in the portfolio). This can happen when two or more schemes in the portfolio invest in a similar set of stocks. While some overlap is inevitable, especially within schemes belonging to a particular category, excessive overlap can significantly dilute the benefits of diversification.

If you hold multiple schemes within the same category, say Large Cap Mutual Funds, it is likely that they have invested in the same set of stocks or follow similar strategies. By mandate, Large Cap Funds invest predominantly in the top 100 securities on a full market capitalisation. So, there could be certain underlying securities that could be common across schemes in the category.

[Read: Here is Why Holding Too Many Similar Mutual Funds Can Drag Your Portfolio Returns]

If the portfolio composition of the schemes is similar to a major extent, i.e., the mutual fund overlap is high, it defeats the purpose of diversification which is mitigating the risk by investing in dissimilar assets, and the sub-asset within them. A high portfolio overlap can also expose the portfolio to concentration risk, leading to polarised returns as it will be skewed towards a few set of stocks, sectors, market cap, or investment styles. If these high-exposure stocks/sectors witness a downturn, all schemes may suffer simultaneously, potentially amplifying losses.

Portfolio overlap can also happen if you concentrate all your investments into the schemes of the same mutual fund house (AMC). Each fund house follows its unique investment philosophy and stock-picking strategy. Hence, it is likely that their investments are biased towards a few stocks or sectors that they expect to perform well over a period. For instance, a Large Cap Fund, a Flexi Cap Fund, and a Large & Midcap Fund of a fund house may have a high portfolio overlap even though they belong to different sub-categories of equity funds if they all are bullish on the prospects of the Banking sector and have prominent exposure in them, resulting in a high number of common stocks.

So, if you invest in several schemes of a fund house that performed exceedingly well in the recent past, due to overlapping of the underlying portfolio, your portfolio may suffer a huge impact if all the schemes underperform at the same time.

How to avoid mutual fund overlap and achieve optimal portfolio diversification?

To ensure optimal diversification and avoid portfolio overlap, you need to conduct a portfolio review and take the following actions:

1) Redeem schemes that do not align with your financial goals

Many investors keep adding mutual fund schemes to their portfolios either driven by emotions, or influenced by peers/family, popularity of the fund, star rating, top performers of the recent past, etc., hoping that it will help the portfolio to deal with volatility. This often results in overlapping portfolios.

Moreover, such investment may not always align with your risk profile, financial goals, or overall asset allocation plan. If individuals clearly define their financial goals, investment horizon, and risk profile, it will help them create a focused portfolio, thus ensuring fair diversification.

[Read: How to Choose Mutual Funds For Your Investment Portfolio]

2) Remove schemes with overlapping investments

If an investor holds multiple schemes within the same category, they have likely invested in the same set of stocks with similar strategies. In this case, it will not add much value to the portfolio. For instance, if an investor owns 3-4 Large Cap Funds, it is unlikely that all of them will turn out to be outperformers. The higher gains in 1-2 schemes may get nullified by lower returns in other schemes, thereby earning returns that align with the market. Consider adding more schemes within the same category only if they follow distinct investment styles or strategies.

In terms of equity mutual funds, one can diversify across various market segments. viz. large cap, mid cap, and small cap, as well as investment styles such as growth and value. For debt mutual funds, select schemes across varying maturities and credit profiles, depending on the financial objectives.

Furthermore, adding one or more low-correlated assets such as Gold/Silver ETF, International Funds, and even Sectoral/Thematic Funds (if your risk appetite permits it), etc. can result in optimal diversification and offer a hedge against volatility.

3) Eliminate consistent underperformers

Persistent underperformance of a mutual fund scheme relative to the category peers and the benchmark index is an important signal for you to consider replacing it with a better alternative. It makes sense to clean up the portfolio in such a case and hold only the ones that have a consistently appealing performance track record. The scheme that one has invested in should be capable of limiting the downside risk during bearish phases by limiting the downside risk better than the benchmark and peers, and generating higher returns than the market as well as the peers during bull phases.

However, avoid judging the scheme/s based solely on its short-term underperformance, say 6-months, 1-year, etc. Also, avoid comparing the performance with a scheme belonging to another category.

[Read: How Many Mutual Funds Should I Invest In? Avoid Over-Diversifying Your Portfolio]

To conclude

As an investor, you need to assess whether the composition of the respective schemes in your portfolio is unique, or else it may result in portfolio overlap, unable to add much value.

Keep in mind that, when two or more mutual fund schemes from the respective category and sub-category have more or less the same securities and are held in almost the same weightage, adding another such scheme defeats the purpose of diversification. Beyond a point, every scheme added to your investment portfolio offers no extra benefit, does not necessarily lower the risk, and increases the burden of managing it.

Consider adding a scheme to the portfolio only if it has a unique investment mandate to offer via its strategy and style. Avoid adding a new scheme to your investment portfolio just because the respective category and sub-category of mutual funds have delivered better returns or there is a New Fund Offer (NFO).

If you need professional help in getting your mutual fund portfolio reviewed, click here to get started.

Wishing you all a very Happy Diwali!

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DIVYA GROVER is the co-editor for FundSelect, the flagship research service of PersonalFN. She is also the co-editor of DebtSelect. Divya is an avid reader which helps her in analysing industry trends and producing insightful articles for PersonalFN’s popular newsletter – Daily Wealth letter, read by over 1.5 lakh subscribers.

Divya joined PersonalFN in 2019 and has since then used stringent quantitative and qualitative parameters to analyse funds to provide honest and unbiased research to investors. She endeavours to enable investors to make an informed investment decision and thereby safeguard their wealth.

Disclaimer: Investment in securities market are subject to market risks, read all the related documents carefully before investing.

This article is for information purposes only and is not meant to influence your investment decisions. It should not be treated as a mutual fund recommendation or advice to make an investment decision in the above-mentioned schemes.