New Delhi [India] October 9: Before you invest your money in mutual funds and stocks, you should know what is in your portfolio. Chances are your portfolio may have significant overlap with other mutual fund schemes, a phenomenon called mutual fund portfolio overlapping.
Understanding mutual fund overlapping is important for managing and diversifying your investment portfolio. This post will explain what mutual fund overlapping is, why it happens and how to avoid it.
What is Mutual Fund Portfolio Overlapping (MFPO)?
Mutual funds are investment vehicles where money from multiple investors is pooled and invested in various assets like stocks, bonds or other securities. A mutual fund buys shares of different companies based on its investment objective. The shares of companies in the mutual fund portfolio represent the collective ownership by the fund’s investors.
When two or more mutual fund schemes hold the same stocks, their portfolios overlap. For example, if Fund A and Fund B both invest in shares of the same company, their portfolios will overlap. Mutual fund portfolios often overlap, sometimes intentionally, because fund managers may have similar investment goals or strategies.
But excessive overlap can lead to concentrated positions and higher risk, reducing diversification. Concentrated positions occur when a mutual fund has a large exposure to a particular stock which can increase risk if that stock underperforms. Excessive overlap reduces diversification by increasing the correlation between the stocks in the portfolio.
Investors may also pay additional fees if they invest in mutual funds with excessive overlap. By investing in the same company through multiple mutual funds, investors may pay additional management fees or other expenses for the same underlying stocks.
Causes and Effects of Mutual Fund Overlapping
Mutual fund portfolio overlapping can be caused by:
●Investment Style: Mutual funds with similar investment philosophies and objectives hold similar stocks in their portfolio. For example, if two mutual funds are large-cap funds, their portfolios will overlap.
●Sector Allocation: Mutual funds that have large allocations to a particular sector or industry will overlap. For example, portfolios of mutual funds investing in pharmaceuticals will overlap.
●Stock Concentration: Mutual fund schemes that hold few high-conviction stocks will overlap with other funds.
●Market Cap Bias: Mutual fund schemes that invest in a particular market capitalisation, say mid-cap or small-cap stocks, will overlap with other funds with similar investment styles.
Effects of Mutual Fund Overlapping
Mutual fund portfolio overlapping may seem like a minor issue, but it can have a significant impact on your portfolio. Here’s why mutual fund overlapping is essential:
●Diversification: Diversification is key to spreading investment risk across different asset classes. Mutual fund overlapping reduces diversification and increases your investment risk.
●Concentration: Overlapping portfolios can lead to concentrated portfolios. If you invest in multiple mutual funds with significant overlap, you may end up with too much exposure to the same investments, industries or investment styles. Concentration risk makes your portfolio more vulnerable to the performance of a particular sector or stock.
●Performance Impact: Mutual fund overlapping can impact your portfolio’s performance. Suppose two or more mutual fund portfolios hold the same security or have significant overlap in sectors. In that case, your investment portfolio’s performance will be disproportionately impacted by the performance of those securities or sectors. This will reduce your overall returns.
How to find Mutual Fund Overlapping?
Finding mutual fund overlapping is easy. Compare the holdings of two or more mutual fund portfolios to check for overlap. Look at the top holdings, sector allocation and market capitalisation of the mutual funds.
How to Avoid Mutual Fund Overlapping?
Some overlap is inevitable when you invest in mutual funds, but excessive overlap can be problematic. Here are some tips to avoid mutual fund overlapping:
●Know Your Investments: Before investing in a mutual fund, make sure you know its investment style, sector allocation and holdings. This will help you to identify potential overlap with other funds in your portfolio.
●Diversify Across Asset Classes: Diversify your portfolio by investing in different asset classes, say stocks, bonds and commodities. This will reduce the impact of overlap within a single asset class.
●Diversify by Sector: Ensure your portfolio has investments in various industries or sectors. This will reduce overlap among mutual funds in your portfolio.
●Use Analytical Tools: Use various tools available to analyse your portfolio and find overlap. These tools will help you to make informed investment decisions.
Benefits of Diversification in Mutual Fund Portfolios
Diversification can reduce risk and potentially increase returns. Diversifying a mutual fund portfolio means combining different securities into one portfolio. By diversifying their portfolios, investors can get:
●Risk Reduction: Diversification minimises the impact of poor performance of a single security on the overall portfolio. Losses in one security can be offset by gains in others.
●Potential Higher Returns: In addition to reducing risks, diversification can also give higher returns. By holding a mix of securities, investors can get the benefits of high returns of riskier securities and the stability of less risky ones.
●Market Trend Advantage: Diversification allows investors to ride different market trends. For instance, if a particular sector is performing well, a diversified portfolio can have stocks from that sector and get higher returns. Conversely, if a sector is underperforming, a diversified portfolio will have limited exposure to it.
●Exposure to Different Asset Classes: Diversification gives exposure to various asset classes like bonds, stocks and real estate, reducing dependence on a single investment.
Conclusion
Mutual fund overlapping can be a double-edged sword. While it can give higher returns, it also increases the risk. Some overlap is inevitable in mutual funds, but excessive overlap can lead to concentrated positions and reduced diversification, defeating the purpose of investing. Investors can make informed decisions by using various mutual fund portfolio overlap tools to track and avoid overlap. Diversifying across multiple funds reduces risk and helps investors to achieve their financial goals more steadily and sustainably. With the right mindset and approach, mutual fund investors can navigate the complex and ever-changing world of financial markets and get the benefits of long-term investing.
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