Portfolio Overlap: This One Mistake Might be Eating Your Returns
Imagine a farmer family who are working on their farm planting only one type of crop.
What happens if the crop is hit by a disease?
All their produce will be at risk, right?
On the other hand, if they grow a mix of crops, even if one fails, other crops will be saved.
This is the idea behind diversification. It saves you from concentration risk.
But over-diversification can be fatal. It can lead to portfolio overlap which in turn causes concentration risk, potential lower returns, and increased cost.
Confused? Let's understand portfolio overlap, its causes and effects, and how to check, reduce, and avoid it.
What is fund overlap?
Have you seen this Venn diagram before? It illustrates two overlapping circles showing a logical relationship between two or more sets of items.
Consider this first circle Mutual Fund A and the second circle Mutual Fund B.
The area where both the circle intersects represents the same stocks or mutual fund portfolio overlap.
So, the higher the overlap, the lesser the diversification. Both funds are investing in the same stocks.
To simplify, let’s take an example of two funds from the same fund house. Mirae Asset Emerging Equity fund and Mirae Asset Tax Saver fund.
Common stocks in mutual funds
Performance comparison
The returns across one, three, and five years are almost identical as well.
However, overlapping does not only occur in the schemes of the same fund house; it can also happen across schemes of multiple fund houses.
Let’s take the example of Canara Robeco Bluechip Equity fund and HDFC Top 100 fund.
Both are large-cap category funds. Let’s analyse the overlap.
There is a significant overlap between these two schemes.
Around 34 stocks overlap. Here is the list of overlapping stocks.
Performance comparison
Both these funds have performed more or less similarly except in a 3-year timeframe.
Now, why does this happen? This brings us to another crucial question.
What causes portfolio overlap?
Regulatory guidelines
Fund houses can pick stocks from a specified universe in a predefined proportion defined by the SEBI mandate.
For example, large-cap funds must invest 80% of their corpus in the top 100 companies by market capitalization.
In contrast, midcap funds must invest 65% of their corpus in 150 companies after the top 100 companies by the market cap.
This is a much larger universe for midcap funds than their large-cap counterparts.
So, the smaller the universe the higher would be the overlap.
Overlap of popular large-cap funds by AUM
Overlap of popular midcap funds by AUM
You can see the table above to see the overlap between the two fund categories.
Another reason for the fund overlap is the funds from the same fund houses with a similar investment style.
Let’s discuss it as well.
Same fund house (style, methodology, and philosophy)
Each fund house follows a specific investment style. Be it value, momentum, or growth.
Additionally, a fund manager has his own bias for picking stocks.
These funds are managed by the same fund managers and you can see the portfolio overlap.
Similarly, there are other reasons for overlapping including:
Sector-specific funds: Funds that focus on specific industries or sectors will have similar stocks.
Benchmark tracking: Most ETFs and index funds track and mimic a particular index. They are likely to have stocks similar to those in the index.
Thus far, we have learnt about portfolio overlap and its causes. Now, let’s see what might be its repercussions.
Effects of Mutual Fund Overlap
Portfolio overlap can do more harm than good. Here are some effects of fund overlapping:
- Concentration risk: Multiple overlapping funds can increase concentration in one security and lead to heavy losses.
- Lower returns: If one security gets affected it multiplies across the funds resulting in low returns.
- High cost: You will pay for multiple funds handling the same securities
- No diversification: With overlapping funds, you are buying similar stocks. So, technically there is no diversification.
Mutual fund overlap can have a huge impact on your overall portfolio.
Is there a way to avoid it? However, first, you should know how to check it.
How to check for overlap in a portfolio online?
There are multiple websites and tools available for mutual fund comparison and overlap. You can visit Advisorkhoj, and navigate to the ‘Mutual fund portfolio overlap’ option in the MF research menu.
Here you can check the overlap in the two funds of a similar category.
How do you check if multiple mutual funds overlap?
You can compare multiple mutual funds overlap by comparing returns, using tools online, and getting help from an expert.
Right now, the most pressing question is how to avoid the overlap.
Let’s answer it.
How do you avoid mutual fund overlap?
Let’s answer it.
To answer this question, you can’t avoid mutual fund overlap by one hundred percent.
There will be undervalued stocks or fast-growing companies that will find a place in multiple portfolios.
Although, there are ways to reduce it.
Let’s find out.
How do you reduce mutual fund overlap?
Avoid funds that don’t align with your goals
On multiple occasions, we act on our emotions and add funds with high star ratings, top performance, or trending funds to our portfolio.
We don’t analyse if they align with our goals or risk profile.
You should immediately redeem these funds that don’t align with your goals.
As these funds can contribute towards overlapping.
Don’t invest in mutual funds of the same fund house
As explained above, fund houses have their specific investment style and bias.
It leads to overlapping.
Diversify across fund categories
Large-cap funds have a limited stock universe to pick. So, they will naturally have overlapping stocks.
You can invest in multiple funds of the same category if they follow different investment styles or strategies.
Review your portfolio timely
Before even investing, you can check the overlap of the funds
Although your funds don’t overlap currently, but they might overlap in the future. So check it periodically.
Eliminate underperformers
Check for the performance of your mutual fund for say over 3 years.
If a fund is consistently underperforming its benchmark or peer, you should remove them from your portfolio.
It will also help you remove the overlap.
Another important question that needs to be answered is how much portfolio overlap is acceptable.
What should be the ideal portfolio overlap?
There isn’t a definitive number, still, you can aim to keep the overlap below 33%.
So, the lower the overlap, the higher the diversification.
We have come to the end of our discussion. Here are the takeaways:
Takeaways
Understand Portfolio Overlap: Portfolio overlap occurs when multiple mutual funds hold the same stocks,
It reduces diversification and increases concentration risk.
It is common in funds within the same category or managed by the same fund house.
Causes of Overlap: Overlap can stem from causes like:
- Regulatory guidelines (e.g., large-cap funds must invest in top 100 companies),
- Investment styles of fund houses,
- Sector-specific funds.
It may occur even across different fund houses investing in similar large-cap or popular stocks.
Consequences of Overlap: High overlap leads to concentration risk, potential lower returns, and higher management fees.
It undermines diversification, which is key to mitigating risk in an investment portfolio.
Check for Overlap Online: You can use online tools like Advisorkhoj’s "Mutual Fund Portfolio Overlap" tool or consult with a financial expert to analyse your mutual funds for overlap
Reduce and Avoid Overlap:
- Avoid funds that don’t match your financial goals or risk profile.
- Diversify across fund categories and fund houses.
- Regularly review your portfolio to identify emerging overlaps
- Eliminate consistent underperformers to refresh your portfolio.
Ideal Portfolio Overlap: Aim for an overlap below 33% to maintain adequate diversification.
Frequently asked questions
What if I invest in multiple mutual funds?
Investing in multiple funds can enhance diversification, but be cautious about overlap.
How do you check the MF portfolio?
You can check your mutual fund portfolio online through various financial platforms like Swaraj Finpro.
How much portfolio overlap is acceptable in a mutual fund?
It is generally advised to aim for less than 33% overlap to maintain diversification.
How can I track all mutual funds in one place?
You can track all your funds in one place through the External MF feature of Swaraj Finpro.
How to compare portfolios of two mutual funds?
Many online tools allow you to compare portfolios of two funds including: Advisorkhoj, Dezerv, etc.
Is there a mutual fund overlap tool?
Several tools such as Advisorkhoj, Morningstar, etc. offer mutual fund overlap analysis.