Investing in mutual funds can prove to be beneficial if you have a diversified portfolio. With the right moves, diversification can help in mitigating the risk involved and improve investment returns over time. However, diversification may not help you if your portfolio overlaps.
While some degree of overlap is to be expected, too much overlap can lead to unnecessary expenses, lower the potential benefits of diversification, and result in a sub-optimal performance. If you are not careful, mutual fund overlap can also lead to taking on more risk than you want or need to. This is because if all of your investments are in the same asset class or sector, they will tend to shift together. This means that if the market fluctuates, your entire portfolio will likely suffer along with it.
Here are four tips to help you avoid mutual fund portfolio overlap effectively.
- Avoid adding different funds managed by the same fund manager
It’s important to diversify your portfolio not only at the asset level but also at the fund manager and AMC level. This is because a fund manager may have similar investment strategies or perspectives towards certain stocks/sectors which they would follow across their mutual fund schemes.
Likewise, you may find some similarities at the AMC level due to a common research team. So ideally, it is advisable to limit your exposure to 30-40% towards an AMC or a fund manager. This will help avoid overlapping of mutual funds and enable you effectively diversify your investments.
- Conduct a side-by-side comparison before buying new funds
Before you add a new fund to your portfolio, take the time to make a side-by-side comparison with the other funds you already own. Start by looking at the classifications for each fund. If the new fund is classified as a large-cap and your existing holding is a small-cap, they probably will not overlap much. But if both funds are classified as large-cap funds, there is a good chance that they will overlap significantly. Next, look at the top holdings for each fund. If the top 10 holdings for the new fund are all in companies that are also in the top 10 holdings for your existing fund, then they may overlap, and you should look for a different option.
Finally, compare the performance of the new fund with that of your existing holdings. If the new fund has performed similarly to your existing holdings over the past 2-3 years, it may not add much value to your portfolio. However, if it has outperformed your other funds, it might be worth adding to your portfolio. When conducting your analysis to identify the portfolio overlap of mutual fund investments, pay attention to factors such as expense ratio, risk level, and asset allocation.
- Consider making changes to your portfolio
Another effective way to avoid MF portfolio overlap is to conduct an asset allocation analysis of your portfolio regularly and to ensure you are optimising your holdings at year-end. This can be done by assessing what portion of your portfolio comprises stocks and bonds versus cash, international holdings, etc. From there, you can identify any gaps or investments that might be causing your portfolio to become overexposed to one asset class.
If there are any overlapping securities, you may want to sell one of the similar funds and reinvest the proceeds into another fund to well-diversify your holdings. Another option is to hold onto both funds but adjust your allocations so that you are not overweight in any company or sector. If you are unsure about making these changes on your own, consult a financial advisor who can help you put together a plan that aligns with your specific goals and needs.
- Make sure your funds have different investment objectives
Another way to avoid overlap in mutual funds is to make sure that each fund has a different investment objective. This will help ensure that each fund is invested in a different group of securities and pursuing a different strategy.
For example, if you have two equity funds, one focused on large-cap stocks and the other on small-cap stocks, you are less likely to experience overlap as compared to a scenario where both funds are focused on large-cap stocks.
It is important to be mindful of the risk of overlap when investing in mutual funds. By taking a closer look at your portfolio and being strategic about which funds you invest in, you can help minimise this risk and maximise your potential for earnings. Moreover, it can be helpful to use one of the many free mutual fund portfolio comparison tools available online to compare the holdings of your mutual funds and identify any overlap.