what is mutual fund overlap

Imagine you’re a chef, and your mutual funds are your ingredients. You’ve got a variety of dishes to prepare (your portfolios), and you want to make sure each one has a unique flavor. But what happens when you start using the same ingredients in all your dishes? That’s right, they all start to taste the same. This is what we call Mutual Fund Portfolio Overlap.

Just like in cooking, in investing, using the same ingredients (or holdings) across different dishes (or schemes) isn’t good for diversification. It’s like putting all your eggs in one basket. If one egg cracks (the value of one scheme drops), all your dishes (other schemes) are affected.

There’s a common misconception that investing in different dishes (schemes) equates to diversification. But true diversification is like using a variety of ingredients (different funds, sectors, etc.) in your dishes.

What is Portfolio Overlap in Mutual Funds?

Now, let’s dive deeper into the kitchen of mutual funds. Mutual fund portfolios are like baskets filled with a variety of ingredients (stocks, bonds, and other investments). The portfolio overlap is the measure of similarity between the ingredients in different baskets. For instance, in equity funds that invest primarily in stocks, there’s a possibility that they’ve all invested in the same companies.

As a chef (investor), you might think it’s a good idea to diversify your dishes (investments) across different types of cuisine (equity funds). But in reality, you might actually be using the same ingredients (investing in the same stocks). This is what we call portfolio overlap in mutual funds, and it decreases the variety of flavors in your kitchen (your portfolio’s diversification).

Causes of Mutual Fund Overlap

Let’s take a look at the causes of mutual fund overlap:

• Market Trends: Market trends influence the investor’s purchasing decision. Sometimes, in the stock market, a specific sector or type of investment becomes popular. As a result, many investors include this popular investment in their portfolios. This gives rise to mutual fund portfolio overlap. Consider this example: If everyone gets excited about a specific bank stock, multiple portfolios may include the same stock.

• Similarity in Investment Strategy: A few factors lead to similar investment strategies. In some cases, fund managers make similar investment decisions based on the same trends or information. There might also be times when they follow popular strategies used by others.

• Building a Portfolio Aligned with Market Index: Investors frequently refer to market indexes when building their investment portfolios. There are numerous index funds and ETFs designed to track these indices. A mutual fund portfolio overlap can occur for investors who invest in multiple index funds and ETFs that track the same index.

Effects of Mutual Fund Overlap

Here are the effects of mutual fund portfolio overlap:

• Reduced Diversification: The mutual fund overlap minimises the diversification of investment. As a result, it makes the portfolio more vulnerable to concentrated risk.

• Diminished Returns: When investments overlap, they can become redundant, resulting in suboptimal portfolio performance.

• Higher costs: Investing in similar stocks through multiple funds may increase transaction and management costs.

• Liquidity: The effect of selling shares in overlapping funds can affect liquidity due to the effect on market prices.

How to Reduce Portfolio Overlap in Holdings?

The following two ways can help you reduce portfolio overlap in your holdings.

1. Diversify the Investment

Diversifying the investment across various funds can help to decrease the portfolio overlap. Investing in different categories reduces the likelihood of overlap because each category includes a different stock.

1. Invest through Multiple AMCs

AMCs invest differently, so you can choose funds from different companies to avoid portfolio overlap. Choose a few different funds rather than all from one source. Different funds from different companies not only reduce overlap but also make your investments more diverse.

Factors to Consider Along with Portfolio Overlap

Besides mutual fund portfolio overlap, there are a few other factors to consider to ensure a well-rounded investment strategy. Consider these factors:

• Investing returns are determined by the weights of the stocks in a fund's portfolio. Thus, even if mutual funds have overlapping asset classes, the weights of common and unique stocks can influence performance. There is a possibility that this won't be the case for very high overlaps, such as 80% or more.

• Consider and evaluate metrics that will provide more insight into aspects such as the amount of risk a fund has taken and its volatility. The fund's standard deviation shows how the returns fluctuate. A fund's Sharpe ratio shows how much risk it has taken to achieve its returns.

• Monthly portfolio changes influence mutual fund overlap. In addition to outperforming its benchmark and category, a fund's consistency is also significant.

• Take note of the track record of the fund manager and the Asset Management Company (AMC). When evaluating a fund, these factors are important to consider.

Conclusion

Achieving absolute zero mutual fund portfolio overlap can be challenging. However, there are ways to reduce portfolio overlap. You can reduce overlap by diversifying your investment across different kinds of assets. Additionally, you may invest through different fund houses to avoid overlap. Moreover, it is best to do research and consult experts to understand investment. Along with mutual fund overlap, be sure to consider the other factors mentioned in the article.

FAQs on Mutual Fund Overlap

How to check if mutual funds portfolios overlap?

Check the portfolio holdings and stock weights of mutual funds to see if they overlap. A mutual fund that has a significant percentage of the same securities in its portfolio is considered to be overlapping. Additionally, you can check mutual fund overlaps on a fund's website or on an online financial portal.

How can portfolio overlap be avoided?

You may avoid portfolio overlap by choosing funds from different companies. By investing in funds from different companies, you not only can reduce overlap but also spread your investments.

How much overlapping in mutual funds is acceptable?

Several factors determine the acceptable amount of mutual fund overlap, including your investment goals, risk tolerance, and time horizon. As a general rule, mutual fund overlaps exceeding 50%-60% should be avoided.

Is overlap acceptable?

There can be some overlap, but it is important to strike a balance to prevent overconcentration. In some sectors, there might be a moderate overlap due to a shared focus.

Note: Views and opinions contained herein are for information purposes only and should not be construed as investment advice/ recommendation to any party or solicitation to buy, sale or hold any security or to adopt any investment strategy. It does not warrant the completeness or accuracy of the information and disclaims all liabilities, losses and damages arising out of the use of this information. The recipient should exercise due caution and/ or seek professional advice before making any decision or entering into any financial obligation based on information, statement or opinion which is expressed herein. No representation or warranty is made as to the accuracy, completeness or fairness of the information and opinions contained herein. The AMC reserves the right to make modifications and alterations to this statement as may be required from time to time.

Statutory Disclaimer: Axis Mutual Fund has been established as a Trust under the Indian Trusts Act, 1882, sponsored by Axis Bank Ltd. (liability restricted to Rs. 1 Lakh). Trustee: Axis Mutual Fund Trustee Ltd. Investment Manager: Axis Asset Management Co. Ltd. (the AMC). Risk Factors: Axis Bank Limited is not liable or responsible for any loss or shortfall resulting from the operation of the scheme.

Mutual Fund Investments are subject to market risks, read all scheme related documents carefully.