If you’re a mutual fund investor, you’ve likely heard of the term “portfolio overlap”. Have you ever wondered why some mutual funds hold the same stocks or companies? This is called portfolio overlap. It’s like using the same ingredients in multiple recipes.
Portfolio overlap happens when mutual funds hold the same stocks or bonds. A little overlap is okay, but too much is like eating the same thing over and over.
What is Portfolio Overlap in Mutual Funds?
Portfolio overlap happens when multiple mutual funds hold the same or similar securities in their portfolios. Imagine you invest in mutual funds with the same or similar stocks. This is an overlap. It can happen if fund investors use the same strategy, follow the same indexes or invest in well-known companies. You can’t tell the two apart.
Knowing why overlap happens will help you avoid it when you invest. Here’s why:
Investment Strategy or Style:
If two fund managers love fast-growing industries like AI, they may both invest heavily in technology stocks. For example, they may buy shares of well-known tech companies. This shared love for tech stocks is their investment style.
When these two growth-oriented funds concentrate on technology stocks, they create overlap in their portfolios. It’s like two friends who frequent the same hangout spot—technology stocks, in this case.
The overlap happens because they have the same investment style and are targeting the same securities. If the technology sector tanks, you may lose even if you have invested in multiple mutual funds.
Investment Universe:
Some mutual funds restrict the types of securities they can invest in based on factors like size, sector, or geographic location. These restrictions create a limited universe of investments, and hence, portfolio overlaps among funds with similar restrictions. For example, two Indian thematic funds that focus on the Indian technology market will invest in similar securities because of their similar investment restrictions and thematic focus.
Benchmark Tracking:
Many mutual funds aim to track or beat specific market benchmarks to align their performance with those indices. So, they include many of the same securities in their benchmark index. This alignment creates overlap. Fund managers select securities to mirror the benchmark to replicate its performance. While this is for benchmark-tracking mutual funds, it can create overlap and show how benchmark selection impacts a fund’s composition.
Concentration of Popular Stocks:
Mutual fund managers react to market trends, economic conditions or company performance metrics. This shared information landscape can lead to similar investment decisions and portfolio overlap.
For example, the Indian Government recently announced Pradhan Mantri Suryodaya Yojana, a scheme to provide rooftop solar systems to one crore Indian households. Such big announcements can change trends, and multiple fund managers will independently invest heavily in top companies in the solar power space. This trend-driven decision-making shows how external factors can align investment strategies, unintentionally create similarities in fund portfolios, and impact overall diversification.
You must be wondering how overlap affects your investments. Here’s why:
The biggest drawback is that portfolio overlap reduces the benefits of diversification. When multiple funds hold the same or similar securities, your portfolio becomes more concentrated in those securities, and the risks associated with those securities increase.
Concentration risks arise when a large portion of your portfolio is exposed to a few securities or sectors. Portfolio overlap can increase this risk by increasing exposure to certain stocks or sectors. If those stocks perform poorly, it can impact your overall portfolio.
Portfolio overlap can lead to higher overall investment costs. These costs can add up fast when you invest in multiple funds and ultimately reduce your net returns. So it may be harder to beat inflation.
Portfolio overlap can amplify losses during market downturns and restrict opportunities for big gains. Sticking to similar investments can make you miss out on new technologies, opportunities, sector rotations, or other developments. If your fund manager doesn’t diversify into different areas, you may miss out on gains.
Investing in mutual funds that hold the same set of stocks severely limits your flexibility. Overlapping holdings can prevent you from adjusting your portfolio in response to market changes or investment opportunities. You may also find it difficult to achieve specific investment goals or optimize your asset allocation.
Now that you know the damage portfolio overlap can cause let’s see how to find it.
Start by reviewing the details of each mutual fund in your portfolio. This information is available in the fund’s prospectus, quarterly or annual reports, or the fund company’s website.
Make a list of all your investments. Document the stocks held by each mutual fund in your portfolio, including the name of the security, the ticker symbol (if available), and the percentage of that holding in the mutual fund’s portfolio.
Step 3: Compare Mutual Fund Holdings.
Look for securities that are common in multiple funds. This will give you a list of overlapping holdings in your portfolio.
To calculate the percentage of overlap, add up the percentages of each holding across all funds. For example, if Fund A has 7% of Stock X and Fund B has 3%, the overlap for Stock X is 3%.
If you want a tool to calculate the overlap in your portfolio, use online financial websites that offer portfolio analysis tools.
To be honest, some overlap is unavoidable. If you’re looking to diversify your investment portfolio, aim to keep the overlap below 33%.
Now, let’s look at some simple solutions to this problem. Be mindful of your investments and portfolio, and you’ll avoid problems.
Spread your investments across different asset classes, including stocks, bonds, and alternative investments (such as commodities or real estate). This will reduce the overlap between asset classes.
In 2018, SEBI created separate universes for different fund categories to ensure consistency and transparency. For example, large-cap funds are required to invest at least 80% of their portfolio in the top 100 companies by market cap. Mid-cap funds have to invest at least 65% of their assets in the top 100, and small-cap funds have to invest at least 65% in stocks outside the top 250 by market cap.
SEBI wanted to bring standardization in investment practices across different fund categories and clarity.
Knowing mutual fund overlap will help you make better investment decisions. Some overlap is normal and expected, but excessive overlap can undermine your portfolio diversification and concentration risk.
You can improve your portfolio performance and reduce risks by identifying and removing overlapping investments and diversifying across asset classes. Watch out for mutual fund overlaps so that your strategy is in sync with your financial goals and you can navigate the market better.
