How to avoid Mutual Fund overlap in your portfolio

Mutual funds have turned into a preferred investment vehicle in the financial market. In the past five years, the Assets Under Management (AUM) in the mutual funds industry doubled from Rs. 22.26 lakh crore in 2019-20 to Rs. 54.1 lakh crore in 2023-24, indicating its sharp growth.

When it comes to building wealth, investors often take the mutual funds route as it offers the advantage of broad market exposure and helps mitigate volatility in the portfolio. It may seem like an almost perfect investment scenario. However, duplicate holdings across different funds can reverse the benefits of diversification, leading to enhanced risks. This is where the concept of mutual fund overlap assumes significance. Understanding portfolio overlap can help to limit the overrepresentation of specific stocks or sectors in the portfolio.        

This blog offers insights into mutual fund overlap, including risks, detection, and strategies to reduce it.

What Is Mutual Fund Overlap?

Mutual fund overlap refers to the common assets or securities between two funds. It signifies the extent of duplicate holdings in the funds in a portfolio.

A key advantage of investing in mutual funds is asset diversification. Investors diversify their portfolios to reduce their chances of suffering losses in the financial market. By investing across various assets, they try to ensure that their portfolio doesn’t take a huge hit when a single holding suffers a negative impact. In other words, investors attempt to spread risk through this technique.

Investing in different mutual funds is an easy and effective way to diversify a portfolio. However, over time, this may lead to investments in common shares, which are part of multiple funds. This is known as mutual fund portfolio overlap.

Portfolio overlap may result in an investor’s funds concentration in the same securities. If these securities perform poorly, it can increase the investor’s exposure to risk.

This makes it necessary to check for portfolio overlap and follow effective strategies to avoid it.

Impact of Mutual Fund Overlap on Investors

Portfolio overlap may cause investors to invest too much funds into the same stocks. This may impact the efficiency of an investment strategy and reduce its return potential. Here are the key impacts or risks of mutual fund overlap.

· Reduced Diversification

Excessive portfolio overlap defeats the purpose of diversification. When investments are concentrated in a limited number of assets, it can reduce an investor’s exposure to different securities.

· Increased Risks

Duplicate investments in a portfolio carry higher risk as the funds are concentrated in specific securities or sectors. This makes the portfolio prone to volatility, thus enhancing its risk profile.

· Reduced Gains

When an investor has an overlapped portfolio, the chance of losing opportunities for earning enhanced gains from a well-diversified portfolio is high. In other words, the investor may end up with lower-than-expected returns due to a lack of exposure to different securities.

· Higher Costs

Investing in multiple mutual funds with similar stocks means an investor must pay unnecessary management fees. These expenses can impact the overall gains earned from the investments. 

· Increased Correlation

The interconnection between mutual fund performances becomes high when multiple funds in a portfolio have overlapping holdings. During market volatility, the returns from such correlated funds may fail to provide the desired benefit of risk mitigation. The portfolio may suffer increased losses due to this correlation.

· Lack of Transparency

An overlapped portfolio often makes it difficult for an investor to assess the overall asset allocation and risk exposure. Due to the lack of clarity on overlapping holdings, the investor may struggle to rebalance their portfolio or make informed decisions about asset reallocation.

How to Identify Mutual Fund Overlap?

Identifying mutual fund overlap involves evaluating all the holdings under different funds in a portfolio. The aim is to identify common holdings across the funds. Analyzing the data enables investors to understand the extent of stock overlap among the funds.

When a portfolio shows high overlap, it indicates the funds are not diversified sufficiently.

Here are a few ways to identify mutual fund portfolio overlap.

· Comprehensive Fund Analysis

A thorough fund analysis is essential to detect similarities in holdings. One must compare all the mutual funds in a portfolio to detect duplicate stocks, assets, or sectors. 

· Analytical Tools Usage

Specialized software tools empower investors to adopt a streamlined approach to their fund analysis. These tools explore the mutual funds to generate a comprehensive analysis report of possible redundancies. Using such tools, investors can make informed decisions about their portfolio diversification.

· Fund Report Evaluation

Every mutual fund provides a detailed report of its investments and holdings. An investor must thoroughly evaluate these reports and mark the top 10 holdings in each mutual fund in the portfolio. If there is any commonality in the stocks or assets, it will indicate a potential portfolio overlap.

· Consultation With Financial Advisors

Financial advisors have the knowledge and expertise to identify overlaps in a portfolio. Investors can seek guidance to detect duplicate assets and balance their portfolios for a more diversified investment approach.

Strategies to Avoid Mutual Fund Overlap

A well-diversified mutual fund portfolio calls for thorough planning and assessment of every investment. As one continues to invest, the scope of overlap will increase. Here are a few strategies to avoid or reduce mutual fund overlap.

· Diversification and Balanced Allocation

Investing across different mutual fund categories, such as debt funds, equity funds, index funds, etc., can help an investor build a resilient portfolio. This strategy minimizes the risk of overinvesting in a single market sector.  

Further, one has to allocate investments after analysing the risk and return ratio to maintain a healthy balance.

· Regular Review of Fund Holdings

It’s not enough to invest once and forget. Mutual fund holdings require regular review to ensure no duplications can creep in. If an investor detects overlap in investments, the next logical step is to shift the investments for better diversification.

· Portfolio Rebalance

The volatile nature of the financial market often leads to changes in mutual fund performances. This may cause an investor’s portfolio to become imbalanced. Periodic analysis of the portfolio’s composition will enable investors to identify such changes.

Based on this, investors can adjust their investments and rebalance their portfolios. However, rebalancing portfolios for higher returns can be a challenge. A simple solution is to use PowerUp Money to optimize portfolios for the best returns.  

Distinct Investment Approach

An effective way to avoid portfolio overlap is to opt for mutual funds following distinct investment approaches. It will optimize the chances of portfolio holdings targeting unique assets or stocks.   

Conclusion

Mutual funds offer great scope for portfolio diversification. However, investors must manage portfolio overlap to ensure they reap the benefits of diversification. By addressing mutual fund overlap through effective strategies, investors can minimize risks and optimize returns.   

Disclaimer: This article’s content is intended solely for informational purposes. Any mistakes, omissions, or results resulting from the use of this information are not PowerUp’s responsibility.