Mutual fund portfolio overlap: what it is and how to avoid it

As an individual, Ankit has always been cautious about his spending habits, since his parents taught him the importance of budgeting and saving money in his childhood. Now that he had secured a well-paying job as an IT professional in a global technology company, Ankit wanted to start saving and investing a portion of his salary. When he noticed how well the Indian equity landscape has been faring over the last few years, he decided to be initiate his investments from that sector. However, as a first-time investor, Ankit did not have much idea of investing and hence, he turned his attention towards mutual funds. Upon noticing the variety of schemes, including equity fund, debt funds, hybrid funds, passive equity funds and passive debt funds, Ankit was confused about how to avoid mutual fund overlap. But, what exactly does the term mean and how can you also avoid mutual fund overlap in your portfolio? Here is everything you need to know.

What Is Portfolio Overlap in Mutual Funds?

A mutual fund portfolio overlap refers to a situation in which your mutual fund portfolio contains duplicated securities, often unintentionally. Let us consider a simple example. Ankit, through his research, came to the conclusion that his requirements would be best served by investing in two schemes – a large cap equity scheme, which comprises the top companies listed on the index, based on their market capitalisation, and a mutual fund scheme focusing on the Pharmaceuticals theme. In this scenario, his portfolio would involve the duplication of large cap pharmaceutical stocks such as Sun Pharma, Divi’s Labs, Cipla, and Dr Reddy’s Labs. Excessive portfolio overlap can lead to concentration risk and diminish the benefits of diversification and therefore, it is crucial to evaluate whether a new scheme under consideration adds unique value or merely contributes to overlap. Adding schemes solely based on historical returns or the appeal of a New Fund Offer (NFO) can lead to an unwieldy and inefficient portfolio plagued by MF overlap.

Why Does Portfolio Overlap Happen?

Overlapping of mutual funds occurs when the same securities appear in different parts of the portfolio, either through various investment avenues or multiple mutual fund schemes. As we saw in Ankit’s case, his preference of a large cap fund and a pharmaceutical themed fund led to an overlap of pharmaceutical stocks which fall under the large cap category. Therefore, when you invest in multiple mutual fund schemes, with the aim of achieving optimal diversification, there is a risk that their underlying portfolios contain similar stocks or follow similar strategies, particularly within the same category. This can lead to mutual fund overlap. Now that you understand the concept of MF portfolio overlap, let us take a look at how this can be avoided or reduced.

How Can You Reduce Portfolio Overlap in Your Holdings?

Firstly, if you already have a portfolio in place and are concerned about mutual fund overlap, you can use a variety of online tools which enable you to assess the same by simply selecting the category and sub-category of the schemes and then entering the names of your schemes. Accordingly, you will be able to find the common stocks in your schemes, along with the percentage at which the overlap has occurred. Secondly, you need to understand that a certain degree of portfolio overlap is common, given the variety of classifications and sub-classifications with common links, as seen in the case of large cap schemes and pharma-themed schemes. To reduce this overlap, you can start by regularly reviewing your portfolio schemes and checking the overlap percentage. You can then exit schemes which do not align with your requirements. Alternatively, if you are at the start of your journey, like Ankit, you should avoid adding schemes which are recommended by your friends or relatives, without checking their alignment with your investor persona. Also avoid picking up more than a couple of schemes from the same category and the same fund house, as these may indicate overlaps. Finally, it is advisable to curtail your diversification to a maximum of 8 to 10 schemes, spread across different asset categories such as equity and debt, market capitalisations, themes and sectors, as such a move would offer you optimal diversification without spreading your corpus too thinly.

Therefore, when building your mutual fund portfolio, the key is to assess your personal investor profile, which consists of your risk appetite, return requirements, investment objectives, and time horizon, before adding any scheme. Adding too many schemes can complicate portfolio management and may result in underperforming investments and overlapping holdings. It is important to prioritise a scheme's unique investment mandate and potential contribution to your portfolio's diversification, rather than chasing recent returns or new offerings. Ultimately, a well-balanced, diversified portfolio aligned with your financial goals is more likely to deliver successful long-term results. Now that you know all the facets of mutual fund overlap, you can reduce this deterrent efficiently.

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