Level | Advanced
What is portfolio overlap? How do I compare mutual fund portfolio overlap?

Rhea, a young mutual fund investor who is primarily an equity fund investor, learns about the importance of diversification from a session on investing that she attends. Her portfolio consists of five equity diversified funds. Over the six months after she attends the session, her portfolio expands to 10 equity diversified funds. She believes that having 10 funds in her portfolio offers her a reasonable amount of diversification. Over the next few months, the stock markets dip significantly; she notices that all her 10 funds record a fall in value in proportion to the fall in the market. She is surprised. Hasn’t she diversified as she’d been advised in the investment session? When Rhea digs deeper into the reasons for the fall in all her fund investments, she comes up with a surprising answer. The investment portfolios of all the 10 funds are very similar. No wonder they perform similarly!

Shruti, another equity investor, invests in equity shares as well as equity funds. Like Rhea, when she checks the portfolio of equity funds in which she has invested, she finds a number of stocks to be the same as those that she has invested in directly.

This is what portfolio overlap is all about – it simply means investing in the same securities through different investment schemes/avenues. While Rhea finds herself dealing with this problem due to investments in multiple schemes of mutual funds with the same investment objective, Shruti finds herself facing this problem due to holding equity securities which are also present in the portfolio of equity funds in which she has invested. Where debt investing is concerned, most of us don’t realize that we have a provident fund account maintained by our employer while, at the same time, we also have a public provident fund account; in reality, both of these are similar.

Mutual fund portfolio

When a mutual fund launches a scheme, it invests the money collected from investors into securities as per the investment objective of the scheme. For instance, in the case of a diversified equity fund, the mutual fund invests in equity shares of companies across different sectors and market capitalizations. Now, most equity diversified funds invest in growth stocks (i.e. stocks of companies that are expected to grow at a higher rate than the overall economic growth rate). Since the investment objective of all equity diversified funds is the same, a significant amount of similar stocks will be featured in the portfolios of all these funds. For instance, if XYZ equity fund has invested in shares of ABC Ltd, PQR equity fund would also have invested in shares of ABC Ltd; in fact, both funds may have invested a similar percentage of their portfolio in shares of ABC Ltd. In other words, the XYZ equity fund and PQR equity fund have an overlap in their portfolio. Now, if the price of ABC’s shares fall, the value of both funds’ portfolio will fall. Rhea finds herself in a situation such as this.

Checking on portfolio overlap

Several portfolio overlap tools are available on the internet to help you check the quantum and quality of overlap between two mutual fund schemes. You can select the funds to be compared and receive a report stating the percentage of portfolio overlap, the number of common stocks and the number of uncommon stocks; the report also provides a list of stocks that overlap with the percentage of each stock held in the portfolio. Simply search on your favorite internet browser for ‘portfolio overlap tools’ and you’ll find many solutions.

Problems with portfolio overlap

Diversification not achieved. Diversification means investing in securities that perform differently in a specific situation. This helps the investor reduce investment risk since if one investment underperforms, another will perform well, thereby reducing the investor’s losses or helping improve the investor’s portfolio performance. This is what Rhea wants to achieve; unfortunately, her attempt at diversification is flawed. To diversify, Rhea should have invested in mutual fund schemes that would perform differently in a specific situation. For instance, if Rhea had invested a part of her investments in debt funds (even though she is more equity-oriented) and in gold exchange-traded funds (ETFs), when equity underperformed, there would be a likelihood that debt and/or gold would perform well; while the equity component of her portfolio would underperform, the performance of debt funds and gold ETFs would help improve her overall portfolio returns.

Avoid unnecessary monitoring. Investing in more funds involves greater effort to monitor the funds’ performance. Rhea now has to spend more time monitoring her investments since she has increased the number of schemes in her portfolio from 5 to 10.

It’s true that some amount of overlap in portfolios of mutual funds will exist. For instance, an equity diversified fund may have invested in a pharmaceutical company’s stock, which also features in the portfolio of a pharmaceutical sector fund. However, the percentage of investment would differ; while the equity diversified fund would have invested a lower percentage in the pharmaceutical stock since it has a greater universe of stocks available for investing, the pharmaceutical fund would have a greater amount of concentration in the pharmaceutical stock. Hence, while an investor cannot completely avoid overlaps, she must attempt to reduce this overlap to the extent possible to achieve suitable diversification. This will also help to mitigate stock correlation and decrease the risk of overexposure/ over-diversification. Therefore, do check the portfolios before you invest.

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Key Takeaways

  • Portfolio overlap means investing in the same securities through different investment schemes/avenues.
  • Usually, mutual fund schemes with the same investment objective have very similar investment portfolios with much the same securities.
  • Due to portfolio overlap, diversification is not achieved.
  • Tools are available online to check portfolio overlap across mutual fund schemes.