What should be the ideal number of mutual funds that you should buy?

One of my friends had 5 mutual funds for investing Rs. 50,000.

You may say more mutual funds = more diversification and more you spread out the risk.

But this might not be true.

Today let's learn about the concept of portfolio overlap and how it can impact your returns.

What is Portfolio Overlap?

Imagine you're preparing for a party and you decide to order pizza from five different restaurants. 

But when the delivery arrives all the pizzas have the same toppings. Disappointing, right? That's what portfolio overlap is like in the world of mutual funds.

For instance, consider the case of two popular mutual funds: the ICICI Prudential Bluechip Fund and the SBI Bluechip Fund. 

These funds have a notable overlap of 44%, meaning they share 27 stocks. This overlap can lead to reduced diversification as both funds are heavily invested in the same blue-chip stocks such as Reliance Industries and HDFC Bank. 

Consequently, if these stocks underperform the investor's entire portfolio may suffer more than if the funds were more distinct in their holdings.

The Hidden Cost of Overlap

So, what’s the big deal with portfolio overlap? Let’s take a closer look at how it impacts your returns:

1. Reduced Diversification: When your portfolio overlaps the purpose of diversifying to reduce risk is defeated. 

For example, if you own five equity mutual funds and all of them have a 5-10% holding in Reliance Industries your exposure to that single stock is much higher than you intended. 

If Reliance Industries takes a hit a significant part of your portfolio will feel the pain and this can significantly impact your returns.

2. Increased Market Risk: Let's say Fund A and Fund B both have 30% of their portfolios in banking stocks. 

If the banking sector experiences a downturn, both funds will likely underperform dragging down your entire portfolio. 

The idea of holding multiple funds is to protect against such sectoral risks but overlap defeats this purpose.

3. Higher Costs with Little Added Value: More funds mean more expense ratios transaction fees and exit loads which can eat into your returns. 

According to a study by Morningstar the average expense ratio for equity funds in India is around 1.5-2% per year. 

If you are holding overlapping funds you’re paying more without actually gaining any substantial benefit in diversification.

How to Identify Portfolio Overlap

Now that you know the impact of overlap let's figure out how to identify it. There are a few ways to check for overlap in your portfolio:

Look at the Top Holdings: Start by comparing the top 10-15 holdings of the funds in your portfolio. 

If you notice that several funds have the same stocks among their top holdings that’s a clear sign of overlap.

Use Online Tools: Tools like Advisorkhoj’s “Mutual fund portfolio overlap” tool or Value Research’s portfolio overlap analysis can provide a detailed view of your portfolio and highlight any redundancies. 

You just need to enter the names of the funds and the tool will show you the percentage of overlap across different funds.

Ways to Minimize Portfolio Overlap

If you realize that your portfolio is overlapping, don't worry. Here are some ways to eliminate or minimize it:

1. Choose Funds with Different Strategies: When selecting funds look for ones that follow different investment strategies or focus on different sectors. For example, you could choose a large-cap fund, a mid-cap fund, and a sectoral fund that focuses on technology or healthcare. This way you achieve real diversification.

2. Limit the Number of Funds: It’s tempting to have multiple funds but experts often suggest sticking to 3-4 funds that cover various segments of the market. For instance a combination of an equity fund, a debt fund and an international fund could offer enough diversification without much overlap.

3. Review Your Portfolio Regularly: Investment is not a ‘set it and forget it’ game. Regularly reviewing your portfolio helps you identify any unwanted overlap. Make adjustments if needed to align your portfolio with your financial goals.

4. Consider Index Funds or ETFs: Index funds or Exchange-Traded Funds (ETFs) can provide broad market exposure with minimal overlap. They usually have lower fees and provide diversified exposure in a single fund.

5. Diversify Across Different AMCs: Investing in funds from different Asset Management Companies (AMCs) can help reduce overlap. 

Different AMCs often have distinct investment philosophies and strategies, which can lead to a more diversified portfolio.

6. Limit Overlap: Aim to keep overlap below 33%. While some overlap is unavoidable, maintaining a lower percentage can help ensure that your portfolio remains diversified and less susceptible to sector-specific downturns.

The Bottom Line

Portfolio overlap might seem like a minor issue, but its impact on your returns can be significant. Instead of blindly accumulating funds, take a moment to breathe, assess your investments, and make sure each fund is adding unique value to your portfolio. Remember, smart investing is not just about spreading your money around—it's about spreading it wisely. 

By minimizing overlap, you'll be on your way to achieving true diversification and maximizing your investment potential.