Mutual Funds: How to spot and fix overlaps for a smarter investment portfolio

They say that you should diversify your investments. And for that, most people after investing for a few years, reach a stage where they have money invested across multiple mutual funds. But do you know what happens when you invest in multiple mutual funds, and unsurprisingly, they have many of the same stocks?

This is what is referred to as mutual fund portfolio overlap. Portfolio overlap is a natural side effect of investing in several funds in your pursuit of diversification. And while it is not possible to eliminate it fully if you invest in several schemes, it should be limited to a reasonable amount.

Given that overlap is practically unavoidable, the next best question is to assess how much is acceptable. There’s no strict rule about this, but a lower overlap is better for diversification.

Let’s take the popular largecap funds category as an example. There are currently 34 schemes in the category. If we narrow down the list by only looking at funds with a minimum AUM of ₹5000 cr and a vintage of at least 3 years, then we still have 12 funds. As you can see below, there can be significant overlaps of up to 69% between two large-cap funds at times.

If you are a largecap oriented investor and you keep adding multiple largecap funds to your portfolio, then there are chances that you will end up with a portfolio with huge overlaps and with most funds owning the same stocks across different schemes.

So, what should you do as an investor to go about selecting the funds to minimise portfolio overlap? A few things that can be kept in mind are:

• Each fund that you invest in, should serve a clear purpose in the portfolio. So, say you want to build a diversified portfolio across different market segments, then you can have a fund/scheme from a few of the market cap-oriented SEBI mutual fund categories like largecap funds, midcap funds, smallcap funds, etc. That way, one can have a crisp portfolio with limited overlaps as each fund will have a clear unique mandate.
• It is best to avoid investing in too many schemes from one market-cap oriented category. Especially in the case of large-cap funds. As per SEBI’s rules, a large cap fund needs to invest at least 80% in large-cap stocks. And given that there are only 100 largecap stocks, the overlaps in large-cap funds are obvious.
• In general, having one fund from such categories is sufficient but given the nature of non-large cap space, having up to 2 schemes from midcap or smallcap space is also fine as long as portfolio size is large enough and the overlap within the schemes is controlled via different investment styles of their fund managers.
• Then there are investors who want to pay more weightage to investment styles. They can then have funds from categories that have more freedom like flexicap funds, focused funds, value funds, contra funds, etc. And if such a portfolio, then has funds that still overlap, then that isn’t an issue; it's more due to investment strategy/style than watertight market-cap reasons and also, portfolio overlap isn’t static and changes periodically.
• If picking multiple funds, best to diversify across AMCs and fund managers. Most AMCs are built on different investment philosophies and frameworks. And each fund manager, though operating within AMC’s frameworks, does have their own investment style. So, if you have too many funds from the same AMC and/or fund managers, then chances of portfolio overlaps will increase.

Investors often put money into new funds without checking if the new fund's investments are similar to those they already own. If the new fund has a lot in common with its existing portfolio, it doesn't provide much extra diversification. This means they're just adding more of the same, which can make their portfolio too focused on a particular investment style or size. 

As a result, the returns may become uneven across different market conditions. To create a well-diversified and balanced portfolio, it's better to choose funds that don't have many overlapping investments with what they already have.

Also, it is best to periodically review portfolio overlap to see if there is a creeping increase in the overlap amongst the funds you have. You definitely cannot eliminate portfolio overlap as some ‘good’ stocks will always attract everyone and hence, be part of multiple funds you hold. But best to have a reasonable low level of overlap than high, other factors being the same.

While portfolio overlaps aren’t disastrous literally, beyond a point, they do tend to limit the benefits of diversification. So, if you are aware of how mutual funds overlap, then you can identify potential redundancies in your portfolio and make intelligent changes to reduce it.

Dev Ashish is a Sebi-registered investment adviser and the founder of Stable Investor.