Mutual fund overlap occurs when the same stocks are invested in different schemes. This may compromise diversification which is a key feature of mutual funds. Investing in many similar schemes in your portfolio is not a good idea as it increases the chances of mutual fund overlap. It is advisable to invest in different fund categories. This article is about the best ways to avoid mutual fund overlap.
What is a Mutual Fund Portfolio?
Upon investing in a mutual fund you construct a portfolio of stocks, bonds, and other financial instruments. Fund types are equity funds, debt funds, and balanced funds.
Debt Fund: A portfolio largely made up of debt instruments is called a debt fund.
Equity Fund: A fund with the majority of its assets invested in equity instruments.
Balanced or Hybrid Fund: A mutual fund that invests in both stocks and bonds.
What is Mutual Fund Portfolio Overlap?
Mutual fund overlap takes place when two or more of the schemes have been invested in similar types of securities. Multiple schemes may hold the same stocks. Diversification may thus not give the expected results. The investor may have invested in different schemes but the overlap prevents the benefits of diversification.
What are the Demerits of Mutual Fund Overlap?
- Makes it more likely you will lose money
- Additional and unnecessary expenses may be incurred
- Reduction in benefits of diversification
- Reduction in liquidity
- Impact on long-term investment returns
How to Avoid Portfolio Overlap?
Invest in Different Asset Classes
Mutual funds can be sorted by large cap, mid cap, small-cap, multi-cap, value funds, contra funds and more by the Securities Exchange Board of India (Sebi).
Nirav Karkera, Head of Research, Fisdom, the stock and mutual fund investing app, says that many miss the crucial part of verifying if an additional fund diversifies investments at the underlying security level. He adds that two or more funds may be frequently invested in similar securities and that this similarity is what is called the overlap. He concludes that this type of overlap in one portfolio may hamper performance by diminishing the effects of diversification.
This is why investing in different asset classes such as large-cap, mid-cap, and others once you have compared the portfolios of multiple fund houses, is crucial.
Eliminate poor performers that lag behind in the mutual fund schemes.
Harshad Chetanwala, a co-founder of MyWealthGrowth.com, says that in general, it is the top 10 – 15 stocks that are most significant in the consolidated portfolio. He adds that a solution is to diversify within high-quality funds that have differing portfolios. He also suggested the creation of a blend of funds across market capitalization as it can also reduce the risk of overdependence on a few companies.
Vinit Khandare, chief executive officer and founder of MyFundBazaar, says that investors must not let multiple funds be handled by the same fund manager. He adds that fund managers create their strategy based on their take on sectors and stocks and that would be reflected in all of the types of funds they manage. Khandare also mentions that in a perfect world the investor would limit their exposure to 30% per fund manager or asset management company.
Kartik Parekh, who is a Sebi-registered investment advisor and co-founder of fintech platform Gochanakya, is of the opinion that investors should minimize overlap because it can reduce the benefits of portfolio diversification. He says that diversification must be done in the correct way.
“Diversification is done to minimise the risk of an investment. Diversification across the same type of funds would not serve the purpose,” says Parekh.
“People can avoid investing in funds which are managed by the same fund manager. It is because fund managers tracking a particular sector/capitalisation may have a strategy or view towards it which may incline their managed fund’s portfolio towards certain stocks” Parekh elaborates.
Limit the Number of Funds You Invest In
It is advisable to limit the number of funds you invest in, in order to limit the chances of mutual fund overlap. Refrain from investing too much in any one asset class. Spread your investments in different fund categories. These should be based on your investment goals and risk tolerance.
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Mutual fund overlap takes place when two or more of the schemes have been invested in similar types of securities.
A portfolio largely made up of debt instruments is called a debt fund.
A fund with the majority of its assets invested in equity instruments.
A mutual fund that invests in both stocks and bonds.