If you are a mutual fund investor, you will want to avoid mutual fund portfolio overlap.
Mutual fund overlap is a common mistake that investors make. But what is the overlap in mutual funds?
Overlapping is a term that refers to an occurrence when investors invest in two or more mutual funds with the same holdings. To know how to avoid it, read the article.
What is mutual fund overlap?
It occurs when an investor invests in various mutual fund schemes with the same holdings. Mutual fund portfolio overlap defies the purpose of diversification. When you invest in similar funds, the performance of one scheme will affect the performance of all the others with the same securities. When a mutual fund portfolio isn't diversified, it increases your risk. A similar situation happens when you invest in funds with the same holdings. Sometimes fund managers can't avoid overlapping because of limited investment options, resulting in counterproductive outcomes. It means diversification with mutual funds can be tricky.What is a mutual fund portfolio?
A mutual fund portfolio means investing in different investment options such as bonds, stocks, bills etc. The fund collected from investors is used in buying various capital assets - bonds, stocks, shares, ETFs etc. Based on it, mutual funds are broadly classified into debt, hybrid, and equity funds. If the fund invests predominantly in debt securities, it is a debt fund. Similarly, an equity mutual fund invests primarily in equities. A hybrid or a balanced fund has equal exposure in both debt and equities. Investors can invest in any mutual fund that suits their needs.What is mutual fund portfolio overlapping?
Portfolio overlapping happens when an investor invests in different funds, but the investment is made into the same company holdings. In this case, the portfolio is not diversified, and the risk actually increases. The portfolio can suffer losses even if the value of one fund decreases. While a small amount of overlap is expected, extreme cases of overlap expose investors to a high level of company or sectoral risk. It is called 'overweighting a sector.' It is an investment situation where a portfolio invests excessively into a particular security compared to the weight of a benchmark portfolio. For instance, a portfolio holds 15% weight on debt, but the exposure has been increased to 25% to earn extra returns. Portfolio managers overweight a portfolio when they believe a sector or company will outperform the other securities in the portfolio. Sometimes overweighting is a strategy to hedge or reduce risk from another security. Selective overweight is an investment strategy. An alternative to it is to distribute the corpus equally between securities or to go underweight on some.Example of a mutual fund portfolio overlap
Suppose you invested in two different mutual funds, A and B. The two funds eventually invest in the same companies or target the same sectors. As a result, if the securities of fund A perform poorly, the chances are fund B will also incur losses. Overall you will experience a loss in your mutual fund portfolio. Mutual fund portfolio overlapping is the opposite of diversification. Diversification mitigates investment risks by spreading the fund in uncorrelated securities. But it is a difficult concept for most investors to understand. Investing in different schemes isn't necessarily diversification. There is no overlap in an ideally diversified portfolio, and the risk is reduced too.How to identify portfolio overlap
It can be challenging for regular investors to track the funds' holdings in run-time. But a quarterly or annual check can help evaluate the investment strategies and compare the top holdings of each fund - the percentage of investment, quality of the overlapping securities, etc. There is software to help you identify portfolio overlapping when you provide your investment details.What to do in case of portfolio overlapping
Overlapping prevents your portfolio from achieving its full potential. Knowledge of different mutual fund categories will help identify overlapping more efficiently.Plan efficiently
Sometimes mutual fund investors invest in multiple funds. If you are doing it, you must stop. Investments of any kind should match your ultimate financial goal.Avoid investing in the same thing twice
Investing in multiple schemes with the same goal increases the chances of portfolio overlapping. For instance, if you have already invested in a large-cap fund, you should choose a different asset class or category for the next investment. Most of the large-cap schemes invest in the same set of companies.Eliminate poor performers from your portfolio
When an investment constantly lags behind the other categories, peers, or the benchmark portfolio, you should replace it from dragging down overall portfolio returns. An easy way to compare the funds' long-term performances.Why should you have a diverse mutual fund portfolio?
The market is unpredictable. Diversification spreads your corpus and hedges against market fluctuations. Overlapping increases your exposure to a sector or a company. It increases your risks and loss even when NAV is falling. Although diversification doesn't guarantee to prevent losses, it minimises your risks. Diversification is essential for long-term investment. Also read Mutual Fund Portfolio Diversification and Its BenefitsFinal words
Mutual funds are a common choice for investors for instant diversification. If investors carefully avoid mutual fund overlap, they can actually do better.
FAQs
What is mutual fund overlap?
Mutual fund portfolio overlapping is when investors invest in multiple schemes with the same holding structure. For example, when fund A and B invest in the same XYZ company stocks, it is portfolio overlapping. Overlap increases the risk of the investor.
What is mutual fund portfolio diversification?
Portfolio diversification spreads the investment into various securities to reduce risk and improve risk-adjusted returns.
How to avoid overlapping?
Follow the steps below.
• Don’t invest in similar types of mutual funds with the same security holding structure.
• Plan efficiently according to your financial goals.
• Review performance and eliminate schemes that aren’t performing.
