Mutual funds are one of the easy-to-use investment options that suit every investor category. With a variety of assets to choose from, mutual funds offer the benefit of investment in a diversified portfolio at reduced risk and less capital. However, in the hoard to invest in quality mutual funds, one may find their investment portfolio quite overlapped. So what is the meaning of mutual fund portfolio overlap and how can one avoid it?
Let’s find out.
What is the meaning of mutual fund portfolio overlap?
Portfolio overlap refers to the degree of similarity in the investments held by different portfolios. It measures to what extent two or more portfolios carry similarities in terms of assets. When investors create multiple portfolios, they often include various assets such as stocks, bonds, mutual funds, or other financial instruments. Portfolio overlap helps evaluate how much these portfolios share in terms of holdings. If two portfolios have a high degree of overlap, it conveys the fact that they own many of the same investments.
Portfolio overlap is important to consider because it affects the inherent benefit of diversification in mutual funds which is a key strategy of spreading investments across different assets to reduce risk. When portfolios have a high degree of overlap, they become less diversified because they are overly dependent on a few common investments. On the other hand, portfolios with low overlap have more diversification and may be better positioned to handle market fluctuations.
What are the possible causes of portfolio overlap?
Portfolio overlap is an unconscious or unintentional outcome of investment in multiple mutual funds. Some of the possible causes for such portfolio overlap are explained hereunder.
The similarity in investment strategy
Every mutual fund has its investment objective and a unique investment strategy to meet that objective. This strategy may involve using an in-house algorithm to allocate resources to specific stocks and other assets and market trends that favour a sector or stock. However, there can be cases where the investment strategies may be more or less similar leading to the selection of the same stocks or assets in the mutual funds. When investors invest in similar mutual funds, the result is a portfolio overlap.
For example: When you invest in 2 or more mutual funds in the same category like Large Cap funds, the stocks held by both mutual funds may be the same to a great extent. This is due to the fact that large-cap mutual funds can invest only in the top 100 stocks as per the Association of Mutual Funds in India.
Change in investment strategy
There are many cases of changes in the investment strategy of mutual funds post the change in their fund managers or due to changes in the investment mandate of the fund. This change in investment strategy can lead to a change in the asset allocation model of the fund.
For an investor, this can be a drastic change if there is a change in the risk-return perception and also a selection of stocks and assets that is similar to another mutual fund already in their portfolio. This can also lead to overlap of portfolio for the investor and they lose the benefit of diversification that they earlier had.
Market trends can influence investment decisions. During certain periods, certain assets or sectors become popular among investors. As a result, many portfolios may include these popular investments, causing overlap. For instance, if there is a surge in renewable energy stocks, multiple portfolios might have investments in this sector. This will again lead to portfolio overlap for the investors.
Portfolio based on a market index
Investors often use market indexes, such as the Sensex or Nifty 50, as benchmarks for their portfolios. These indexes represent a collection of stocks considered representative of the market. There are many index funds and ETFs that focus on these indices and create their fund. Investment in multiple index funds and ETFs that track the same index can also lead to portfolio overlap for investors.
Popular stocks being added by investors and mutual funds alike
Portfolio overlap can occur when certain stocks become popular among both individual investors and mutual funds. This popularity can stem from factors like impressive performance or widespread market hype. As a result, a large number of investors and mutual funds rush to buy these popular stocks, leading to a situation where multiple portfolios and funds end up holding the same investments.
Can portfolio overlap be avoided?
While it’s challenging to completely avoid portfolio overlap, there are strategies you can employ to minimise it. The key is diversification. Diversifying your investments means spreading them across different types of assets, like stocks, bonds, and real estate, as well as various sectors such as technology, healthcare, and finance. By doing so, you reduce the chances of holding the same investments as others.
Additionally, conducting independent research and exploring lesser-known stocks or niche sectors can help you uncover unique investment opportunities that are less likely to overlap with popular choices. Regularly monitoring your portfolio and making adjustments as needed, such as selling duplicated investments and diversifying into other assets, can further reduce overlap.
Customisation is the perfect tool for creating a healthy investment portfolio. It is important to tailor the investment strategy to your individual goals and risk tolerance, rather than relying solely on standardised recommendations. While it may not be possible to completely avoid overlap, following these steps can help you create a well-diversified portfolio that stands out from the crowd.
Mutual fund investment is an accidental happening and needs to be corrected at the earliest. It defeats the very purpose of investing in mutual funds and having a diversified portfolio. Multiple reasons lead to the overlapping of the mutual fund portfolio and it is necessary to identify these factors to rectify the error. Therefore, regular monitoring of the mutual fund portfolio and rebalancing the same is of paramount importance to avoid any possibility of mutual fund portfolio overlap.
The acceptable range of portfolio overlap in mutual funds is approximately 60%.
The easiest way of checking if the mutual fund portfolios overlapped is by comparing the holdings of mutual funds focusing on the same segment of stocks or other assets.
The golden rule of investing in mutual funds is to invest from a very early stage and to take the benefit of compounding and rupee cost averaging on the investments.
There are two ways of investing in mutual funds i.e., either through SIPs or through lump sum mode.