What is Mutual Fund Portfolio Overlap? Tips to Avoid It

Mutual funds are among the easiest and most suitable investment options for all types of investors. With a wide range of choices, mutual funds offer the advantages of a diversified portfolio with lower risk and less capital. However, when you invest in multiple mutual funds, you may find that their portfolios overlap significantly. So, what exactly is mutual fund portfolio overlap, and how can you avoid it?

What Is Mutual Fund Portfolio Overlap?

Portfolio overlap occurs when two or more funds in a portfolio share similar investments, such as the same stocks or bonds. While mutual funds are designed to offer diversification, high overlap reduces this benefit, concentrating risk in fewer assets.

For example, investing in two large-cap funds might result in both holding shares of the same top-performing companies, thereby limiting the variety in your portfolio.

Why Does It Matter?

Diversification—the backbone of mutual fund investing—is about spreading risk. Overlap undermines this principle, making your portfolio more vulnerable to market fluctuations. Conversely, portfolios with minimal overlap tend to be more robust during market downturns.

Causes of Portfolio Overlap

Portfolio overlap can happen unintentionally or intentionally when investing in multiple mutual funds. The potential causes of this overlap include:

1. Similar Investment Strategies

Each mutual fund has a specific investment goal and follows a unique strategy to achieve that goal. This might involve using a particular approach to allocate funds to specific stocks or sectors based on market trends. However, in some cases, investment strategies may be similar across funds, leading to the selection of overlapping assets. For example, if you invest in two or more mutual funds within the same category, such as large-cap funds, their stock portfolios could significantly overlap. According to the Association of Mutual Funds in India, large-cap mutual funds tend to invest in the same top 100 stocks.

2. Changes in Investment Strategy

There are instances when a mutual fund’s investment strategy changes, either due to a new fund manager or an updated investment policy. These changes may alter the fund’s asset allocation approach. If the new strategy aligns with other funds in investors' portfolios, this can lead to unexpected portfolio overlap, diminishing the benefits of diversification.

3. Market Trends

Market trends can influence investment decisions. At certain times, specific sectors or assets may become popular with investors. As a result, multiple portfolios may include these favored investment options, leading to overlap. For instance, during a surge in renewable energy stocks, several portfolios might contain investments in this sector, causing overlap for investors.

4. Index-Based Portfolios

Investors often use market indexes like Nifty 50 and Sensex as benchmarks for their portfolios. These indexes are composed of stocks that represent the broader market. Several index funds and exchange-traded funds (ETFs) track these indices and build their portfolios accordingly. Investing in multiple index funds or ETFs that follow the same index can lead to significant portfolio overlap.

5. Popular Stocks in Mutual Funds

Portfolio overlap can occur when certain stocks become popular among individual investors and mutual funds. This may be due to factors like strong performance or market hype. As a result, multiple portfolios end up holding the same stocks, increasing overlap.

Can Portfolio Overlap Be Prevented?

While it’s challenging to eliminate all portfolio overlap, there are ways to minimize it. The key is diversification. Diversifying your investments means spreading them across various asset classes, such as stocks, bonds, and real estate, as well as across different sectors like healthcare, technology, and finance. By doing this, you reduce the chances of holding the same investments in other portfolios.

Additionally, conducting your research and exploring lesser-known stocks or niche sectors can help you discover new investment opportunities that are less likely to overlap with popular options. Regularly monitoring your portfolio and making adjustments when necessary, such as selling duplicate investments or diversifying into different assets, can further reduce overlap.

Customizing your portfolio is another important strategy. Tailoring your investments to your personal goals and risk tolerance rather than relying solely on generic recommendations can help you create a more balanced and distinct portfolio. While it’s impossible to avoid overlap entirely, following these steps can help you build a well-diversified portfolio.

Conclusion

Mutual fund portfolio overlap is a common issue that needs to be addressed promptly. It undermines the goal of mutual fund investing and the purpose of maintaining a diversified portfolio. Several factors can lead to portfolio overlap, and it’s essential to identify the cause to rectify the situation. Regularly reviewing and rebalancing your mutual fund portfolio is crucial to ensure that overlap is minimized and your investments remain well-diversified.