Investing in a mutual fund is a good way of beating the inflation and earning decent returns and many small investors are doing same for years. But when deciding number of schemes there is a high chance of mutual fund overlapping.
In this article, I’ll highlight all the important things about scheme overlapping and give tips to avoid such scenario so your chance of winning increases.
Mutual fund overlapping occurs when an investor holds multiple mutual funds that have similar or identical underlying assets, such as stocks, bonds, or other securities. In essence, overlapping happens when different mutual funds in an investor’s portfolio invest in the same companies or sectors.
While diversification is one of the key benefits of mutual funds, overlapping defeats this purpose by creating redundancy. For instance, if you invest in two equity funds, both of which have significant holdings in large-cap stocks such as Reliance, HDFC Bank, TCS, and ITC, your portfolio ends up being concentrated in those stocks.
This leads to a lack of actual diversification and exposes your portfolio to higher risks and defeats the purpose if those stocks or sectors underperform.
Why Should You Look Into Mutual Fund Overlapping?
Overlapping in mutual funds can have several implications for your investment strategy, and it is crucial to evaluate it for the following reasons:
False Sense of Diversification: Investors often assume that investing in multiple funds means their portfolio is diversified. However, if these funds hold similar stocks or assets, diversification is not effectively achieved. You’ll just have identical schemes.
Higher Risk Exposure: Overlapping increases your exposure to specific stocks or sectors. If those assets perform poorly, your portfolio could face substantial losses.
Inefficient Use of Capital: Holding multiple funds with overlapping assets may lead to redundant investments, which is an inefficient use of your money. It may also increase costs due to unnecessary fund management fees come with each scheme.
Complicated Portfolio Management: Monitoring a portfolio with overlapping funds can become challenging. It makes it harder to assess your actual exposure to sectors, industries, or geographies (overseas investments).
Tax Implications: Overlapping can inadvertently lead to similar capital gains distributions across funds, which may increase your tax liability.
Why Is Mutual Fund Overlapping a Big Concern?
Mutual fund overlapping is a concern because it undermines the primary benefits of mutual fund investing, which are diversification and risk mitigation. Here’s why it matters:
Concentration Risk: When multiple funds hold the same stocks, your portfolio’s performance becomes overly dependent on a limited set of assets. This increases your vulnerability to market fluctuations in specific stocks or sectors.
Reduced Portfolio Efficiency: Overlapping does not add value to your portfolio but rather inflates the number of funds unnecessarily. This results in higher expenses without proportional returns.
Missed Opportunities: By allocating capital to overlapping funds, you miss the chance to invest in truly diverse and potentially high-performing sectors or assets.
Complex Decision-Making: Overlapping adds layers of complexity when rebalancing or restructuring your portfolio. It’s harder to identify areas of underperformance or overexposure.
How Much Mutual Fund Overlapping Is Okay?
Technically there is no set of rule for acceptable overlapping, but a moderate level of overlap is generally acceptable, but excessive overlap can lead to unintended risks and reduced returns. Here’s a breakdown of how much overlap is okay:
1. Ideal Overlap Range: 20% to 30%.
An overlap of 20% to 30% is typically considered acceptable, as it allows for some common holdings without significantly reducing diversification. This range ensures that you’re not excessively exposed to the same stocks or sectors.
2. Moderate Overlap: 30% to 40%.
If the overlap is 30% to 40%, it’s still manageable but requires closer monitoring. At this level, review your portfolio to ensure that the overlapping stocks align with your investment goals. Also consider Total Expense Ration (TER) in account.
3. High Overlap: 40% and Above.
Overlap above 40% is considered high and may defeat the purpose of having different or multiple funds. High overlap can expose you to sector-specific or company-specific risks, reducing diversification benefits.
Ways To Avoid Mutual Fund Overlapping.
Avoiding overlapping requires diligent research, regular monitoring, and a strategic approach to portfolio construction.
Here are practical ways to minimize or eliminate overlapping:
Analyze Fund Portfolios: Before investing, review the holdings of mutual funds. Many fund houses and financial platforms provide details about the top holdings and sector allocation of funds. Check for common stocks or sectors across your existing and potential investments.
Use Overlap Check Tools: Leverage online tools and calculators designed to identify overlap between funds. These tools analyze fund portfolios and highlight the degree of overlap to help you make informed decisions.
Diversify by Investment Style: Invest in funds with different investment styles, such as large-cap, mid-cap, small-cap, or thematic funds. This ensures exposure to varied market segments and reduces the likelihood of overlap.
Choose Sector-Specific Funds Carefully: Avoid investing in multiple sectoral or thematic funds that focus on the same industry, such as IT, healthcare, or banking. Instead, limit sectoral exposure to one or two funds per sector.
Monitor Regularly: Periodically review your portfolio to identify and address overlapping issues. As market dynamics change, the overlap between funds may increase over time.
Work with a Financial Advisor: Consult with a financial advisor who can assess your portfolio and recommend strategies to minimize overlap while maintaining optimal diversification.
Opt for Index Funds or ETFs: Index funds and exchange-traded funds (ETFs) often have transparent holdings. This makes it easier to identify overlap and construct a diversified portfolio.
Some Tips to Reduce Overlap.
Although there isn’t much to tell more but here is my all wisdom in short:
- Diversify across different fund categories (large-cap, mid-cap, small-cap).
- Choose funds with different investment styles (growth vs. value).
- Focus on fund managers’ strategies to ensure varied approaches.
Take help expert to review your portfolio’s overlap or use tools for analysis! 😊
Conclusion.
Mutual fund overlapping is a common issue that can erode the benefits of diversification and increase risks in your portfolio.
By understanding what overlapping is and why it matters, you can take proactive steps to identify and minimize it. Conducting thorough research, utilizing mutual fund overlap analysis tools, and diversifying thoughtfully are key to building a balanced and efficient portfolio that can generate wealth over time.
Remember, the goal of investing in mutual funds is not just to grow wealth but to do so with an optimal balance of risk and return. Eliminating redundancy and focusing on genuine diversification will help you achieve this goal.
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