Managing Portfolio Overlap

When you buy mutual funds, you are actually purchasing a portfolio of securities. These securities might be stocks, bonds, REITs, derivatives, or a mix of them. There are around 1,590 mutual funds as of today, of which 441 are open-ended equity mutual funds, 349 are Debt Funds, 172 are Hybrid Funds, 254 are Exchange Traded Funds (ETF), Fund of Funds (FoFs) and gold mutual funds, and 374 are closed-ended and interval funds.  

As a result, picking funds becomes a difficult process. This is exacerbated when each major category, such as equity and debt, is further subdivided into sub-categories comprising several mutual fund alternatives offered by various asset management companies (AMC). For example, in the Large-Cap equity mutual fund category, there are now roughly 32 choices. And there is a perception that adding more such high-yielding funds will help them achieve better gains. However, this is not the case because it would result in overdiversification.

Diversification is one of the most effective methods that help investors in lowering the overall portfolio risk. However, doing too much or too little might endanger your portfolio. Adding more funds to your mutual fund portfolio frequently results in overdiversification. The value of diversification begins to wane beyond a certain point. This is most likely the outcome of overlapping in the portfolio. As a result, in this piece, we will learn about portfolio overlapping, its influence, how to avoid it, and how to optimise your mutual fund portfolio.

What is Portfolio Overlap?
When you invest in two or more mutual funds that invest in the same asset, such as stocks, you have mutual fund portfolio overlap. You diversify your financial portfolio by investing in several funds. If the funds you invested in acquire the same assets, you will not achieve your goal of diversifying your

portfolio. Investors also add more equity funds from the same category to prevent concentration risk. However, just investing more in similar equity funds would not eliminate portfolio concentration risk. This is because, while mutual funds may have different names, they almost always invest in the same stocks. Portfolio overlap is a common result of this. Companyspecific risk or sector-specific risk may exist in your portfolio. You don’t want your portfolio to rely too much on a few stocks. Portfolio overlap undermines the entire goal of diversification.

Illustration ― Understanding this by example would aid in minimising portfolio overlap. You may utilise numerous tools accessible on the internet to do this. For the sake of demonstration, we chose the two best-performing large-cap, Mid-Cap and Small-Cap funds during the previous five years.

The top performing large-cap funds in the previous five years were Canara Robeco Bluechip Equity Fund and Axis Bluechip Fund. The two graphs above demonstrate how these two funds’ holdings overlap. As you can see, Axis Bluechip Fund shares 90 per cent of its holdings with Canara Robeco Bluechip Equity Fund, while Canara Robeco Bluechip Equity shares 70 per cent of its holdings with Axis Bluechip Fund. In all, the average portfolio overlap is 67.2 per cent. This suggests that these two funds share an average of 67 per cent of the securities. As a result, collectively investing in these two funds makes little sense; rather, investing in only one of them would be appropriate.

Mid-Cap Mutual Fund

Although we can see some overlapping even in mid-cap funds, it is rather minor in nature. When compared to the large-cap funds we recently looked at, Quant Mid-Cap Fund and PGIM India Mid-Cap Opportunities Fund have very little portfolio overlap. Quant Mid-Cap Fund shares 28 per cent of the same holdings as PGIM India Mid-Cap Opportunities Fund, whereas PGIM India Mid-Cap Opportunities Fund shares 16 per cent. The average portfolio overlap is only 12.3 per cent. This implies you may easily invest in these two funds since they might result in higher diversification.

Small-Cap Mutual Fund

When it comes to small-cap funds, the overlap appears to be much narrower than it is for mid-cap and large-cap funds. We examined the overlap between Quant Small-Cap Fund and Axis Small-Cap Fund and discovered that it is not a major worry for these two funds. As of June 30, 2022, just two stocks are common in these two funds. This brings the overlapping to only 6.1 per cent. As a result, even among small-cap funds, these two funds provide enough diversification.

However, it is worth noting that we have used Quant Mid-Cap Fund and Quant Small-Cap Fund as examples, which have completely different investing strategies. These funds trade more often and have a more focused portfolio. Furthermore, because the allowable investment universe for small-cap funds is on the upper end, the odds of portfolio overlapping are fairly low

Impact of Portfolio Overlap
Diversification is the practise of investing in securities that perform differently in different situations. This helps the investor decrease investment risk because if one investment underperforms, another will outperform, decreasing the investor’s losses or improving portfolio performance. You should put money into mutual fund schemes that might behave differently in a particular circumstance if you want to diversify. For example, if you invest a portion of your portfolio in debt funds (despite having aggressive risk profile) and gold ETFs, when equities underperform, debt and/or gold are likely to outperform. In this situation, despite the fact that the portfolio’s equity component is failing, the performance of debt funds and gold ETFs would assist in enhancing your overall portfolio returns and safeguard the downside. Portfolio overlap also results in extra monitoring. Investing in additional funds necessitates a higher effort to monitor the performance of the funds and also necessitates more time spent monitoring your investments. Let’s look at portfolio overlap from the standpoint of financial planning. One thing to look for in any portfolio is how effectively you can spread your risk or how well your portfolio serves as an automated risk mitigator.

Beyond a certain point, portfolio overlap diminishes the benefits of diversity, increases risk, and is the antagonist of portfolio diversification. As a mutual fund investor, just adding more funds to your portfolio will not diversify your portfolio. The funds must also be distinct in terms of strategy and asset composition. Diversification of the portfolio occurs only when the funds in which you invest distribute money among several asset classes. If the asset class in which your funds have invested suffers losses, the portfolio’s total loss will be increased if there is an overlap. That is why the overlap should be kept to a minimum. Overlap cannot be avoided since you might need to invest in more than one fund to minimise over-reliance on a single fund. Take a thorough look at the portfolio composition, though.

How to Avoid Portfolio Overlap?
Here are some guidelines you need to keep in mind:

Understanding the Investment Style ― Understanding the investment style of the fund manager will help you prevent portfolio overlap. A style matrix might assist you in comprehending the same. A style matrix is a graphical depiction of the features of a mutual fund, such as value, blend or growth, as well as the asset-weighted size, which might be large-cap, mid-cap, or small-cap. The style matrix assists you in understanding the investing style of the fund manager. This will enable you in avoiding investing in the same type of funds. For example, if you currently possess a mid-cap fund that focuses on value investing, consulting the style matrix will assist you avoid investing in funds with comparable qualities.

Examining the Fund’s Top Holdings ― Any two mutual funds’ portfolios may appear very different. However, you must be conscious if you have an excessive amount of a certain stock. If you have two large-cap funds and both fund managers have made substantial bets on HDFC Bank, your company-specific risk will grow. Investing in a few funds allows you to study each fund’s top holdings and weights to determine whether comparable investments are slanted towards a specific company. If you have too many funds in your portfolio, you may consult with your financial adviser or seek for tools on the internet to assist you grasp the same.

Be Mindful while Investing in Sector Funds ― Sector funds are an excellent illustration of portfolio overlap. Assume you are investing in an IT fund, a popular investment option in recent years. There is a greater likelihood that two IT funds have the same holdings, but their weightages may differ. However, if the sector begins to decline, your total portfolio will fall at the same rate. On the contrary, if you invested with limited portfolio overlap, your portfolio is unlikely to collapse at a higher rate.

Avoid having too many Large-Cap Funds ― Advisors frequently discuss how large-caps are a safe investment. This is due to the fact that large-cap stocks are simple to acquire and comprehend. Most large-cap funds, however, invest in almost

the same stocks. Most of them may invest in companies from the Sensex, Nifty, or, at the most, the Nifty 100 index. Understand that the universe of large-cap stocks is quite narrow. According to the Securities and Exchange Board of India (SEBI), only the top 100 stocks in terms of market capitalisation are considered large-caps. Furthermore, a large-cap fund should devote at least 80 per cent of its assets to the universe of the top 100. As a result, buying in too many large-cap funds may result in portfolio overlap.

Avoid investing in funds of the same Fund Manager ― It is commonly assumed that if the fund is managed by a star fund manager, it would provide strong returns. As a result, investors frequently make the error of investing in all those funds managed by that star fund manager. Every fund manager has his or her own investment style and beliefs, which they may adhere to regardless of the fund they manage. For example, if a fund manager is optimistic on a specific company, he may own it in all of the funds that he manages. As a result, investors who invest in all of their funds are taking on additional stock-specific risk since the percentage of that stock in their portfolio will increase. Furthermore, this increases portfolio overlap.

Optimising Your Portfolio
Consider the following tips to optimise your portfolio:

Strive for Optimum Diversification ― To reduce portfolio risk, optimal diversification is required. Aligning your investments with your goals, risk tolerance, and investing horizon can help you achieve the best possible diversification. Large-cap funds are appropriate if you have a moderate risk tolerance and want to generate consistent returns over time. Add no more than one or two schemes of the same category. This will allow you to track the development of the plans toward your objectives. Keep in mind that most individual investors only need 5-10 mutual fund schemes, depending on the size of their portfolio. These schemes might include equity funds, debt funds, hybrid funds, and Equity Linked Saving Scheme (ELSS). If you invest via systematic investment plan (SIP) each month, three to four funds are enough to construct a well-diversified portfolio.

Remove Persistent Underperformers ― Remove the scheme

that continuously performs below its benchmark and the category average if you have added many schemes to the same category. The proceeds from the plan may be invested in the scheme or schemes that are yielding great results. Do not, however, base your selection simply on short-term underperformers. The fund should be able to actively engage during recovery and bull phases while also protecting against downside risk during bear phases.

that continuously performs below its benchmark and the category average if you have added many schemes to the same category. The proceeds from the plan may be invested in the scheme or schemes that are yielding great results. Do not, however, base your selection simply on short-term underperformers. The fund should be able to actively engage during recovery and bull phases while also protecting against downside risk during bear phases.

Analyse the scheme on several risk ― reward characteristics such as performance throughout market phases, Sharpe ratio, Sortino ratio, standard deviation and so on to determine whether it is a consistent performer. Consider the relevance of qualitative criteria such as the scheme’s portfolio characteristics, the efficiency of the fund house, and the competence of the fund management team when assessing the consistency of a scheme’s performance.

Stay Away from NFOs ― Investors frequently add freshly launched schemes in the hope of diversifying their portfolio. If the New Fund Offer (NFO) has a comparable investment goal and is benchmarked against the same index, the portfolio is likely to overlap with your existing mutual fund schemes. Furthermore, when you invest in an NFO, there is no solid track record of the fund’s performance, portfolio quality, risk-return profile and so on that may assist you in judging the scheme’s worthiness. This makes NFOs a riskier investment, and you would be better off limiting NFOs. If you are ready to accept the risk, you should consider adding NFOs to your portfolio if they provide a unique offering that is not currently accessible in the market and if it corresponds with your financial goals.

Conclusion
One of the most frequently seen aspects is portfolio overlap. With the increasing penetration of mutual funds and NFO launches, it is rather evident to hold schemes that have a similar strategy and holding to a fund that you may currently have. Portfolio overlap is the result of a large number of funds in the portfolio, which would not only become unmanageable over time but would also give no additional advantage of diversification. In fact, having a portfolio overlap might significantly reduce your returns. As seen in our illustration, the portfolio overlap diminishes as the investing universe expands. Largecap funds had the most portfolio overlap in our example, followed by mid-cap funds and small-cap funds which had very little. However, this does not rule out the possibility of portfolio overlap between mid-cap and small-cap funds. Before you contemplate investing in any fund, determine whether it has any similarities to any of your existing funds. Investing objectives, fund managers, investing styles and portfolio holdings can all be identical. Remember that adding comparable funds does not provide diversification. In fact, it is the result of combining funds with various themes and asset classes.