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INTRODUCTION:
If you are a mutual fund investor you must have heard people talk about “portfolio overlapping.” Have you ever wondered why some of your mutual funds seem to have the same companies or securities in them? Because these funds overlap with each other. That’s simply called portfolio overlapping. It’s like having the same ingredients in different recipes.
So, when does the Mutual Fund Portfolio Overlap?
Overlapping happens when different mutual funds own similar stocks or bonds. While a bit of overlap is okay, having too much can be compared to eating the same meal over and over again.
In this article, we will discuss overlapping in your portfolio– what it is, why it happens, how much of an overlap is admissible, and what you can do to not let it hamper your financial dreams.
So, let’s get started–
Table of Contents:
1) WHAT IS PORTFOLIO OVERLAP?
2) WHY DOES PORTFOLIO OVERLAP OCCUR?
3) HOW DOES PORTFOLIO OVERLAP AFFECT YOUR INVESTMENT PROFILE?
4) HOW TO FIND OVERLAP IN YOUR PORTFOLIO?
5) HOW MUCH OVERLAPPING IS FINE IN MUTUAL FUNDS?
6) HOW CAN YOU FIX PORTFOLIO OVERLAPPING?
7) CONCLUSION
1.)WHAT IS PORTFOLIO OVERLAP?
So, what is Portfolio Overlap in mutual funds? It is a situation where multiple mutual funds hold similar or identical securities within their portfolios.
Let’s say you happen to invest in different mutual funds that own the same or similar stocks in their portfolios. This will lead to an overlap. This can occur if the fund investors follow identical strategies, track the same market indexes, or invest in the same famous companies.
It’s like having different cuisines but having the same style of cooking and the ingredients so much so that you cannot distinguish between them.
To help you get a deeper understanding of this, let’s consider a real-life example. Let’s say you have two mutual funds: ICICI Prudential Bluechip and SBI Blue Chip. Both funds belong to the blue-chip category. Hence they might have some overlap in their portfolios– meaning, they have a common stock that they may invest in.
Blue Chip category of funds can be typically termed as Large Cap Funds owned by the same fund house. If you wish to get a glimpse of what a Large Cap Fund signifies, then click on the video link below:
Some of the overlapped stocks are as below.
What does this mean?
This means that for instance, a change in ICICI Bank’s stock price would affect both funds’ performances, thereby affecting your investment. As the universe of the blue chip companies is smaller, many such funds tend to have this high overlap.
Blue Chip Companies are those that are ranked in the top 100 by Market Capitalization.
2.)WHY DOES PORTFOLIO OVERLAP OCCUR?
Now, this is a very valid question. Knowing why overlapping happens in the first place will help you prevent that while investing. So, what are some of the popular reasons why overlapping occurs?
1. Investment Style or Strategy: For instance, let’s say there are two fund managers or fund houses that love the idea of the rapidly growing industry, say AI, and they want their money to grow fast. They might end up investing a lot in technology stocks, like buying shares in popular tech companies. This shared interest in technology stocks is what we call their investment style.
So, when these two growth-oriented managers/funds focus heavily on technology stocks, it creates an overlap in their portfolios. It’s a bit like these friends having the same favorite hangout spots – in this case, the technology stocks. This overlap happens because their investment strategies are alike, and they end up investing in similar types of securities.
Suppose the technology sector underperforms then you as an investor might need to face a significant hit despite investing in multiple Mutual Funds.
2. Limited Universe of Investments: Certain mutual funds impose restrictions on the types of securities/universe they can invest in, encompassing factors like size, sector, or geographical location. These predefined boundaries create a specific universe of potential investments for these funds.
Consequently, this can result in portfolio overlap where multiple funds share comparable restrictions.
For instance, let us consider the scenario in Indian thematic funds. Suppose there are two funds, both focusing on the technology sector within the Indian market.
Due to their thematic concentration and adherence to similar investment restrictions within the technology domain, these funds might find themselves investing in overlapping securities.
This highlights the fact, how boundaries or constraints set by funds, particularly in thematic contexts, can contribute to shared investments and subsequently lead to portfolio overlap, influencing the overall diversification of an investor’s portfolio.
For instance, the below screenshot compares the 2 different Digital/Technology funds and their portfolio overlap.
This is a common phenomenon when you choose the same category of funds under different fund houses. Comparing new Mutual Fund holdings with existing Mutual Fund holdings will help you overcome this challenge effectively.
3. Benchmark Tracking Numerous mutual funds aim to either track or surpass specific market benchmarks, aligning their performance with these indices. In pursuit of benchmark returns, these funds often include many of the same securities present in the benchmark index, creating a situation of overlap.
This occurs as fund managers strategically select securities that mirror those constituting the benchmark, aiming to replicate its performance.
While this alignment is intentional for benchmark-mirroring funds, it introduces a degree of overlap in holdings, emphasizing the influence of benchmark choices on a fund’s composition.
Some mutual funds have restrictions on the types of securities they can invest in, such as size, sector, or even geographic location. This limited universe of investments can lead to overlap with other funds that have similar restrictions. Classic examples are the various passive funds out there that just try to mimic their respective benchmarks.
4. Concentration in Popular Stocks: Certain Mutual fund managers respond to common market trends, economic conditions, or company performance metrics. This shared information landscape can lead them to make similar investment decisions, causing portfolio overlap.
For instance, the Indian Government recently announced the Pradhan Mantri Suryodaya Yojana’, a government scheme under which one crore households will get rooftop solar power systems. So, when there is such a huge announcement, the trends change and the stocks/companies around the solar power sector may do well due to the robust growth that may lie ahead.
So multiple fund managers may independently opt for substantial investments in leading companies, resulting in overlapping holdings across various funds. This trend-driven decision-making underscores how external factors can synchronize investment strategies, unintentionally fostering similarity in fund portfolios and potentially impacting overall diversification.
Up till now, we have discussed the various factors or reasons leading to portfolio overlap in your Mutual Fund Portfolio. Moving on let’s analyse the impact of portfolio overlap on your investment profile and to future Financial Goals.
3.)HOW DOES PORTFOLIO OVERLAP AFFECT YOUR INVESTMENT PROFILE?
You might wonder– what does overlapping do to an investment? Let’s read through to understand the adverse effects.
1. Reduced Diversification:
This is the biggest disadvantage of overlapping. Overlapping holdings across multiple mutual funds reduces the benefits of diversification. If multiple funds hold the same or similar securities, your portfolio becomes more concentrated in those assets, increasing the risk associated with the performance in those particular holdings.
2. Increased Concentration Risk: Concentration risk arises when a significant portion of your portfolio is exposed to a limited number of securities or sectors. Portfolio overlap increases this risk as it increases your exposure to specific stocks or sectors. If those holdings perform poorly, it may be harmful to the overall investment portfolio.
3. Higher Costs: Overlapping will increase your total investment costs. How? Each fund charges management fees and other expenses, and these costs can add up quickly when holding similar investments across multiple funds. This reduces your net returns over time. So it makes it harder for you as an investor to generate returns that surpass inflation.
4. Limited Upside Potential: Portfolio overlap not only has the potential to magnify losses when markets decline but can also restrict the chances of significant gains. Moreover, sticking to similar investments might cause you to miss out on emerging technologies and opportunities arising from sector rotations and other trends. If your fund manager avoids diversifying into different areas, you might lose the chance to benefit from potential gains in those sectors.
5. Lack of Flexibility: Flexibility is highly reduced if you invest in mutual funds that have invested in the same stock pool. Overlapping holdings may limit your ability to adjust your portfolio strategically in response to changing market conditions or investment opportunities.
It can also hinder your ability to achieve specific investment goals or optimize your asset allocation.
4.)HOW TO FIND OVERLAP IN YOUR PORTFOLIO?
So, now that we know what kind of damages overlapping can potentially do to your investment portfolio let’s see how you can simply find the overlaps
Step 1. Review Fund Holdings: First of all, do your research and find out all the information for each mutual fund shareholding in your portfolio. You can typically find this information in the fund’s prospectus, quarterly or annual reports, or on the fund company’s website.
If you are wondering how many Mutual Funds to invest in your Investment Portfolio here is a video to guide you in your Mutual Fund Investments.
Step 2. Create a Consolidated List: See everything you’re investing in. After you find out the securities held by each mutual fund in your portfolio, write them down. Include the name of the security, the ticker symbol (if available), and the percentage of the fund’s portfolio allocated to each holding.
Step 3. Identify Common Holdings: Compare the consolidated lists of holdings across all your mutual funds. Look for securities that appear in multiple funds. These are the overlapping holdings in your portfolio.
Step 4. Calculate Overlap Percentage: Find out the overlapping percentage first. It’s easy– to calculate the overlap percentage for each common holding, and you have to sum the percentages allocated to that holding across all funds. For example, if Fund A holds 7% of Stock X and Fund B holds 3% of Stock X, the total overlap percentage for Stock X is 3%.
Step 5. Consider Rebalancing: If you find significant overlap in your portfolio, try rebalancing by either reducing exposure to overlapping holdings or reallocating funds to other investments to achieve better diversification.
Use Tools and Resources: In case you want AI to figure out the overlapping percentage in your portfolio, then use the most used tool-GOOGLE. Several online financial websites offer portfolio analysis tools that can help you identify overlap and assess the diversification of your portfolio more efficiently. For instance, Thefundoo is a good tool that you can use to track your portfolio effortlessly.
To enlighten you more on the effectiveness of the tool we prescribe you to watch our video on:
Regularly monitoring and managing overlap in your portfolio can help you make sure that you maintain a well-diversified investment strategy aligned with your financial goals and risk tolerance.
5.)HOW MUCH OVERLAPPING IS FINE IN MUTUAL FUNDS?
This is a very legit question– “How much overlapping is fine in mutual funds?” Well, overlapping is inevitable, to be honest. No matter what, there will always be a small fraction of it in the portfolio. If you’re considering diversifying your portfolio, then target to keep an overlapping percentage less than 33%.
Let’s see an example to understand this. There are two dishes– spaghetti and pizza. Imagine you have two chefs: Chef A specializes in making spaghetti, and Chef B is known for making pizza. Now, both chefs have decided to collaborate and create a new menu for a restaurant.
Chef A’s spaghetti dish consists mainly of pasta, tomato sauce, and meatballs. Meanwhile, Chef B’s pizza includes a dough base, tomato sauce, cheese, and pepperoni.
While there is some overlap in ingredients (tomato sauce) between the two dishes, the overall composition and focus of each dish are different.
Similarly, in mutual funds, having less than 33% overlapping means that while there might be some shared investments (like the tomato sauce in our food example), the majority of the portfolios are distinct, with their own unique set of investments (like the meatballs in spaghetti and pepperoni on pizza).
This level of overlapping is generally considered acceptable because it allows for diversification across different assets while still maintaining a degree of uniqueness and focus in each fund.
Now, the last part of this– how do you fix it?
6.)HOW CAN YOU FIX PORTFOLIO OVERLAPPING?
So, now there are some really easy ways to fix this. Before we go through them, know that being self-conscious about your portfolio and investments will always come in handy.
Let’s see how you can fix overlapping in a few simple steps–
1. Diversify across Asset Classes:
Make sure that your portfolio is diversified across different asset classes, such as stocks, bonds, and possibly alternative investments like real estate or commodities. This can help you reduce overlap within each asset class. Do check out our earlier blog on how to diversify your portfolio.
2. Diversify across Categories:
In 2018, SEBI established distinct universes for various fund categories, aiming to enhance consistency and transparency. Large-cap funds were mandated to invest 80% in the top 100 stocks by market size. Mid-cap funds, on the other hand, were required to allocate at least 65% of their portfolio to the 150 stocks following the top 100 by market size.
Similarly, small-cap funds were instructed to invest a minimum of 65% of their portfolio in stocks beyond the top 250 stocks by market size. This move by SEBI sought to provide clear guidelines and standardize investment practices across different fund categories.
Bonus: A video to help discover the different categories and Mutual Funds that exist.
So if you are planning to invest in 2 or more funds from the same categories then there may be higher overlap considering their respective universe sizes. So it is better off to invest in different categories to stay away from the adverse impact of the portfolio overlap.
3. Diversify across AMCs: If all your funds come from the same AMC, portfolio overlaps can occur due to the AMC’s distinctive investment styles. Each AMC adheres to a specific philosophy and methodology in selecting investments, and fund managers may exhibit biases in their stock-picking approaches.
Consequently, this may result in the inclusion of common stocks or stocks from the same sectors in various funds, even if these funds belong to different categories. The underlying consistency in AMC’s approach can inadvertently lead to overlapping holdings across different funds within the same asset management company.
4. Review portfolio overlap periodically: Reviewing portfolio overlap is crucial to align with your desired investment strategy. Regularly assess your portfolio to ensure it stays within your predetermined limits. Even if the initial overlap is low, conduct the reviews every six months, especially considering that fund managers frequently adjust portfolios.
This practice helps prevent unexpected increases in overlap, maintaining a well-balanced and diversified investment approach.
Keep track of any shifts in holdings to adapt your portfolio to changing market conditions, fund manager decisions, and evolving investment landscapes.
For more insights on Portfolio Review, you can watch our video on:
Regular reviews empower you to make informed adjustments, safeguarding your investment portfolio from excessive overlap and potential risks.
5. Seek Professional Advice: If you’re unsure about how to address overlap in your portfolio, consider consulting with a holistic financial advisor who can provide personalized recommendations based on your investment goals, risk tolerance, and financial situation.
By taking these steps, you can effectively address overlapping in your portfolio and ensure it remains well-diversified and aligned with your investment objectives.
7.)CONCLUSION
As said earlier, investment requires us to bear a lot of responsibilities. Not only diversification, we also have to be careful about portfolio overlapping. Though overlapping to an extent is fine, it starts discarding you of all the benefits once it is very high.
Portfolio overlap in mutual funds can weaken the risk-return profile of your investment portfolio, increase costs, and limit hundreds of diversification benefits. As an investor, we need to be mindful of overlap while constructing our portfolios.
You can consolidate your holdings and look for diversification across different asset classes, investment styles, and geographical regions to mitigate these risks effectively.
Happy Investing!!!
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