What Is Mutual Fund Overlap?

An investor thinks that having too many schemes in their portfolio will lead to diversification, but it is not true. Even if you have invested in too many schemes, you might end up investing in similar stocks because of mutual fund overlapping.

In today’s blog post, we will give you the answer to your question: what is mutual fund overlap?

What is Mutual Fund Overlap?

A mutual fund overlap is a condition in which two or more mutual fund schemes of your portfolio hold common stocks. This mutual fund overlap causes you to invest in the same companies even after investing in different schemes. This eventually reduces the primary purpose of diversification through a mutual fund. A mutual fund overlap can increase the risk in the portfolio by investing in a specific sector or individual security. 

Example of Mutual Fund Overlap

Let’s understand the example of mutual fund overlap through an example.

Mr A has invested in two funds, namely Fund A and Fund B.

Fund A belongs to the large-cap category, and Fund B belongs to the flexi-cap category. Now analyse the top 5 holdings of these two funds.

Holding of Fund A

Name of Stock	Weightage in Portfolio
Reliance Industries Limited	10%
HDFC Bank Limited	8%
TCS Limited	8%
Infosys Limited	7%
ICICI Bank Limited	6%

Holding of Fund B

Name of Stock	Weightage in Portfolio
Reliance Industries Limited	9%
HDFC Bank Limited	9%
TCS Limited	8%
Bharti Airtel Limited	6%
Larsen and Toubro Limited	5%

Now, let’s identify the overlap in Fund A and Fund B

The following stocks are common to fund A and fund B

1. Reliance Industries Limited
2. HDFC Bank Limited
3. TCS

If you have invested 10,000 in each fund A & B, your total exposure in Reliance Industries will be around:

1000 in Fund A and 9000 in Fund B, and a total exposure of around 1900 INR.

Similarly: HDFC Bank: ₹800 + ₹900 = ₹1,700 & TCS: ₹800 + ₹800 = ₹1,600

Types of Mutual Fund Overlap

The key types of mutual fund overlap are as follows:

• Stock Overlap: This is one of the most common types of mutual fund overlap. It generally happens when two mutual funds hold the common stock in their portfolio.
• Sectoral Overlap: Sector overlap happens when different mutual fund schemes invest in the same sector or industry, even when the individual stocks are different. 
• Overlap in Market Capitalisation: This type of overlap happens when multiple funds invest in companies having market capitalisation of a similar category, such as large-cap, small-cap, etc.
• Investment Style Overlap: This overlap occurs when the different schemes in which you have invested follow similar investment strategies, such as a value strategy, a growth-oriented strategy, etc.
• Category Overlap: This usually occurs when an investor is used to investing in a similar category of mutual fund. For example, if an investor invests in two large-cap funds.

Read Also: Top Reasons Why Mutual Funds Are Going Down

Benefits of Reducing Portfolio Overlap

The key benefits of reducing portfolio overlap are as follows:

• Diversification: Reducing portfolio overlap increases the diversification and reduces the overall portfolio risk. If the investments are spread across asset classes, stocks, sectors, etc., the performance of your portfolio will increase.
• Concentration Risk: Overexposure to a particular stock, sector, etc., might lead to poor performance of a portfolio and can negatively impact the returns.
• Long-Term Growth: Investment across different market segments allows investors to gain benefits from various growth opportunities.
• Portfolio Rebalancing: Portfolios having different funds and portfolios are simpler to review and rebalance. One can easily identify the underperforming funds and make an informed investment decision. 

Reason for Mutual Fund Overlap

The key reasons for mutual fund overlap are as follows:

• Regulatory Mandate: The SEBI has introduced the categorisation rule for asset management companies on what they can buy under the regulation. Due to this mandate, the investable universe is restricted.
• Investment Objective: Lots of mutual funds have similar investment goals, such as long-term capital appreciation, which increases the chance of fund overlap.
• Sector Performance: Sometimes, when a particular sector has strong growth potential in the future, every fund manager focuses on that sector and takes some allocation in it. This may lead to portfolio overlap.

Effects of Mutual Fund Overlap on Investors

The key effects of mutual fund overlap on investors are as follows:

• Less Diversification: One of the key impacts on investors due to mutual fund overlap is that it reduces diversification. If various mutual fund holds same stocks, it concentrates your portfolio.
• Limited Return: If an investor owns mutual funds that have similar holdings, then the investor is supposed to get limited returns because of lesser diversification.
• Higher Volatility: Generally, a portfolio with high overlap is considered more volatile as it becomes more sensitive to market fluctuations. As the common stocks in the portfolio face a sharp correction, your portfolio will decline simultaneously.
• Sectoral Imbalance in Portfolio: In case of portfolio overlap, an excessive exposure to a few specific sectors, such as IT, banking, etc., can lead to an imbalance in sectoral allocation of the portfolio.

How to Identify Portfolio Overlap in a Mutual Fund?

There are very few methods through which an investor can identify the overlap in their portfolio:

• Comparison of Holding: One of the easiest ways to identify overlap in the portfolio is to compare the top holdings of the funds in which you have invested.
• Checking Percentage: Instead of looking only for the names of stocks having common holdings, one can also check the percentage of identical holdings.
• Using Tools: There are various tools available in the market through which one can calculate the portfolio overlap, as they can easily compare two or more mutual fund schemes.
• Checking Sectoral Allocation: Along with the common stocks, an investor can also check the sectoral allocation in the portfolio and identify if they are heavily invested in the same sector.

How to Avoid Portfolio Mutual Fund Overlap?

The steps to avoid portfolio overlap are as follows:

• Identify your investment objective: Before investing in a mutual fund, one should know their financial goal, risk tolerance, and investment horizon. It helps in allocating your portfolio in a proper manner.
• Avoid Multiple Categories: An investor should avoid investing in two or three funds of the same category to avoid overlapping of funds. As they have similar investment objectives and stocks.
• Diversification across asset classes: To eliminate risk in the portfolio, one is required to diversify their portfolio across different asset classes such as equity, debt, hybrid, etc.

Read Also: Best SIP Plan for 10 Years in India

Conclusion

On a concluding note, portfolio overlap is very common today, especially among new mutual fund investors. Without knowing the disadvantages of it, they tend to invest in similar types of schemes. This can adversely impact their portfolio returns, especially in the case of a volatile market. Therefore, a well-diversified portfolio across different schemes, sectors and asset classes helps an investor in optimising their returns. However, over-diversification may also lead to certain disadvantages; therefore, it is advisable to consult your investment advisor before making any investment in mutual funds. Invest smarter with Pocketful by accessing 2,000+ mutual fund schemes with zero brokerage and a seamless digital investing experience. 

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