Mutual Fund Overlap – Definition, How To Check and Reduce Fund Overlap, Challenges

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A portfolio refers to the collection of various investment holdings of an individual. When it comes to mutual funds, an individual can own many of them: debt, equity, small-cap, or even IT and pharma. Your list of entire mutual fund holdings is referred to as your mutual fund portfolio.

The importance of having a diverse portfolio cannot be underestimated. Long-term investors, especially, try to avoid funds that invest in the same underlying securities to hedge any market correction-related risks.

The choice of mutual funds for diversification majorly depends on factors such as your risk appetite, financial goals, and investment horizon. For instance, if your financial objective is to earn a fixed income, and you want the capital to be safe, you might prefer debt instruments. That fund would be called a debt fund.

However, if you end up investing in multiple funds that invest in similar debt instruments, your portfolio will end up having an overlap. Let us further understand what mutual funds overlap is.

This article covers:

What is mutual fund overlap?

If an investor invests the savings in multiple mutual funds which have the same holdings/asset allocation, there is an overlap of funds. This defies your objective of diversifying the portfolio and makes you prone to market risk. To diversify your portfolio, you should invest in different mutual funds managed by different asset management companies.

For example, let us say that you, as an investor, invest in AB’s small-cap mutual fund. After some time, you see that XY’s small-cap mutual fund is giving more returns, then you start a SIP in XY’s mutual fund as well. In this scenario, both AB and XY mutual fund portfolio holdings are similar. That is, they both invest in the same companies. This is termed fund overlapping.

How does mutual fund overlap work?

If two different funds try to achieve the same goal, they might overlap each other.

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For instance, the Exchange Traded Fund (ETF) of two different AMCs will replicate the index to give similar returns. In that case, you will not want to invest your capital in the same fund where the degree of overlapping is high. 

Sometimes, at the time of your investment, the two small-cap funds could be investing in different companies, but with time, their holdings start replicating each other. It is also possible that the fund shifts its goal. This behaviour is also called style drift.

Changing managers may also lead to the overlapping of funds. Therefore, the best solution is to constantly monitor your portfolio and fund components. This will keep you informed if your funds are overlapping, so you can take corrective action accordingly.

What’s the next step after finding out that your portfolio is overlapping? 

Generally, once investors find out that their portfolio is overlapping with the same assets, the recommended course of action is to opt for mutual fund redemption. This is because the fund has ceased to fulfil the diversification objective and has made you more prone to capital erosion. Therefore, it is better to redeem one of the funds if the majority of the asset allocation is similar.

How to redeem a mutual fund?

This is the most common question that arises among mutual fund investors. Here are some ways to redeem a mutual fund.

If your investment type is direct, you can redeem the mutual funds directly through Asset Management Company’s (AMC) website. The units of your mutual funds can be sold directly on the website. Once the redemption is accepted and the mutual fund units are sold, the proceeds are directly deposited into your account.

If you have invested in mutual funds via a trading or Demat account, you can sell units directly on the platform. After the units are sold, the proceeds are transferred back into your Demat account, which you can credit into the bank account.

However, if you invested in mutual funds via different agents or distributors, you can redeem the fund online on their websites or mobile applications. The proceeds are then transferred into your bank account via NEFT or RTGs.

How do you reduce the overlapping of your mutual fund investment? 

Generally, we invest in mutual funds to diversify our portfolio and protect our money from various market-related risks. Therefore, if our investment products or companies overlap, the motive of diversification fails. Thus, to reduce overlapping, you need to understand the different types of mutual funds so you can make informed decisions.

  • Debt funds: These allocate the pooled money into money market instruments to earn a fixed income. The fund allocation into the money market reduces the risk of investment and diversifies investor’s portfolios into risk-free asset classes.
  • Equity funds: These are the riskiest types of mutual funds as the allocation of funds is primarily in equity markets. However, to compensate for the risk, they offer higher returns as compared to debt funds. Equity funds can also be sub-categorized into small-cap, mid-cap, and large-cap funds.
  • Balanced/hybrid funds: these funds invest in both debt and equity. Therefore, the risk of investing in hybrid funds is lower as compared to equity funds, but higher as compared to debt funds. 
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Technology has made it even more convenient to avoid overlapping your portfolio. There are various aggregator websites available today where you just have to input the name of a scheme, and the website will show you other funds with the same portfolio holdings.

How are returns affected by overlapping? 

One of the biggest reasons investors prefer mutual funds is because they are inherently diversified. Thus, when funds are allocated in the same sector/companies, the benefits of diversification can sometimes be set off.  In such a case, if the pharma sector is not doing well, both of your funds that invest in pharma will be performing poorly. However, this can benefit you well if the pharma sector is doing well.

Despite this, experienced investors are encouraged to find investments with negative correlations, so as to hedge against market risk.

What are the difficulties with mutual fund portfolio overlap?

Diversification goal is not achieved

The main motive of mutual funds is to diversify the portfolio and hedge the risk against market instabilities. Overlapping of funds goes against that motive, and in fact, a fund overlap maximizes stock market-related risk.

For instance, an investor who has more direct exposure to the equity segment should invest in debt mutual funds or gold exchange-traded funds to hedge the risk against a market crash. The two usually show a negative correlation, and if the stock market crashes, the chances of gold prices rising are high. Thus, this diversification of the portfolio will help save capital from erosion.

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Needs unnecessary monitoring

If the mutual fund portfolio is overlapping, then you will have to spend more time monitoring mutual fund investments. Therefore, it is recommended to redeem one of your funds if your overlap is higher than 10%.

Does looking for different managers work? 

The investment goal and style of investment of the majority of fund managers are the same. The philosophy behind making money is the same when the financial objective is similar, therefore, the stock selection might be the same as well.

Therefore, diversifying and selecting different fund managers can also help an investor to avoid fund overlap. Also, avoid investing in too many funds from the same manager.

The Indian stock market only has 5,215 listed companies. Therefore, it is impossible to not have an overlapping portfolio. For example, a bluechip equity fund will have the top IT companies, and an IT fund will also have top-level IT companies. However, what matters is the percentage of the overlap. It is your responsibility as a smart investor to manage this overlap, so your capital remains truly diversified, and is hedged against market volatility.

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