You did everything right. You have gone through researching the funds; you have diversified into various categories of funds, chosen a large-cap fund here, a flexi-cap fund there, perhaps added a sector fund to make things more interesting — and ended up holding as many as five, six or even seven mutual funds. It all looks great on paper — but here’s an uncomfortable truth that few investors ever care to ask: How much of that money is being invested into the same set of stocks, repeatedly?
Welcome to Mutual Fund Overlap, and here’s a look at what it really means, why it occurs, and what you can do about it.
What is Mutual Fund Overlap?
Mutual Fund Overlap occurs when you have multiple mutual funds in your portfolio that invest in the same stocks. Hence, even though you may be holding many different funds, you are essentially betting your money on the same underlying companies.
Here is a common example worth keeping in mind. Assume you have two large-cap funds from different fund houses. Now consider the fact that since both funds are drawing from a pool of the same top 100 market-cap companies, including the likes of HDFC Bank, Reliance, ICICI Bank, Infosys, etc., it is very likely that both funds could have as much as 60-70% of their stocks in common, only in different proportions.
As a result, while you are under the impression that you now have greater diversification by investing in a second fund, in reality you have just strengthened your position in the same stocks.
Why Does Mutual Fund Overlap Happen?
In India, overlaps in investment portfolios are not a bad thing. It often happens because of the way active funds operate in India. Here are a couple of reasons:
Smaller Universe of Good Stocks: There are not that many listed, liquid, and good-quality companies in the large-cap category in India. All fund managers look at the top 30 to 40 large-cap companies where money-making opportunities and liquidity are high.
Similar Mandates: If you have two funds that are in the same category, like two large-cap funds or two flexi-cap funds, there is a high likelihood that their mandates are similar, as they are fishing in the same pond.
Index-Hugging Strategy: Even though many actively managed funds charge active management fees, they do not stray too much from their benchmark indices. Such “closet indexing” practice means that the portfolios of funds from different houses are likely to be alike.
Common Stock Trends: Whenever a few stocks are doing too well or are regarded as must-haves in a certain industry (such as banking or IT), the majority of fund managers have huge exposures to those stocks irrespective of their investment style.
Investing in Multiple Funds of Same AMC: If you have chosen to invest in some schemes of a particular Asset Management Company, the risk of overlap is even greater because fund managers in the same asset management house sometimes share stock research and stock convictions.
Why Should You Actually Care About Overlap?
It is easy to think that, “Oh well, maybe there’s a bit of overlap. At least I know I am investing in sound companies.” Unfortunately, this overlap is doing serious damage to the whole idea of diversification and here’s why:
The Illusion of Lowering Risks
Your whole idea about having multiple funds is to lower risks, but if your funds have too much overlap, you are actually accumulating risks while thinking that you are diversifying them. All it takes is a single correction of a handful of stocks in your overlap segment, and your whole portfolio is impacted.
Excessive Fees on Duplicates
Each mutual fund comes with an expense ratio. When you invest in two or three funds which actually hold similar baskets of stocks, you are essentially paying extra fees for the same thing.
Difficulty Managing True Asset Allocation
Because of the high overlap, your actual holdings in one stock or sector may be much larger than what you can see from the fact sheet of the fund.
Reduced Portfolio Efficiency
If your portfolio has a lot of overlap, it behaves as if it was a single fund rather than a diverse portfolio of stocks.
How to Check Mutual Fund Overlap in Your Portfolio
The good news is that checking for overlap doesn’t require a finance degree. Here are practical ways to do it:
Use Online Overlap Checker Tools Several financial platforms and portfolio analysis websites offer free mutual fund overlap calculators. You simply select the funds you hold, and the tool shows you the percentage of common stocks and the weight they carry in each fund.
Compare Fund Fact Sheets Manually. Every mutual fund publishes a monthly fact sheet listing its top holdings. For a manual (if slightly tedious) check, you can compare the top 10-15 holdings of each fund you own and see how much they coincide.
Review Your Portfolio via Your Investment App or Advisor. Many investment platforms and robo-advisory apps now include built-in overlap analysis as part of their portfolio health check features. If you work with a financial adviser, this is also something they should be reviewing periodically on your behalf.
Check Category-Wise Before Investing. Before adding a new fund to your portfolio, it helps to check its category and compare its top holdings with your existing funds. This proactive approach prevents overlap before it even becomes a problem.
How Much Overlap is “Too Much”?
There is no one-size-fits-all answer, but in general, many portfolio managers use the following criteria for overlap:
Less than 30%: Generally very good diversification.
30-50%: Should be monitored; you have some redundancy, but this may not be unacceptable depending upon how strongly you feel about the funds.
More than 50%: Indicates high levels of duplication. At this level, you may be paying for several funds but achieving the diversification equivalent to that of a single fund.
Note that overlap is virtually inevitable, particularly amongst large-cap and flexi-cap funds in India. The goal is not to achieve zero overlap but rather to avoid too much accidental duplication.
How to Reduce Mutual Fund Overlap
In case you have found some overlaps in your portfolio, below is how to remedy the situation without panicking.
Diversify on Categories, Not Only on Fund Names. Rather than buying several big-cap mutual funds, try to invest in different categories of funds such as big cap, mid cap, small cap, debt and international funds because these categories inherently lead to reduced overlaps at the stock level.
Limit the Number of Funds Within a Certain Category. The possession of more than one or two funds within a particular category usually does not diversify much. This approach is often more effective when you put more belief into one or two well-researched funds per category.
Diversify on Fund Houses and Not Only Fund Names. There are certain fund houses whose fund management philosophy is completely different from one another, such as value investing, growth investing and contrarian investing.
Periodic Review and Rebalancing: Market conditions and fund allocations will continue to evolve over time. A fund that you had low overlap with a year ago may now have a lot more stocks than what was previously held. Periodic reviewing of the portfolio every six to twelve months will help you identify any such changes.
But Don’t Over Diversify Either: Although high overlap does pose a risk, having multiple funds simply to diversify can prove to be equally ineffective. Studies have shown that after a certain number of funds (6 to 8, generally), more funds do not add any value to the portfolio.
A Quick Example to Put This Into Perspective
Consider a case where the investor has four funds – two large-cap funds, one flexi-cap fund, and another one which is large and mid-cap. At face value, there is a reasonable amount of diversification of investment across the various types. However, when you carry out an overlap test, it will be observed that the two large-cap funds have 65 percent overlap between them, while the flexi-cap fund has a 40 percent overlap with the large-cap funds since it is currently investing in large-cap stocks.
In such a scenario, the investor is not as diversified as he thinks from the number of funds in his portfolio. A better diversified portfolio would be achieved through inclusion of a completely different type of fund.
Final Thoughts
Mutual Fund Overlap is an investment risk that is often overlooked. It does not raise any warnings in your statement of investments and is not something most investors consider, yet in many cases it is as dangerous as it may quietly rob them of the benefits of diversification the investors expect.
At the same time, the solution is easy. To get rid of Mutual Fund Overlap a person should regularly check for overlaps between funds and be selective about fund categories and names instead of haphazardly choosing funds. A portfolio with four or even five carefully selected truly diversified funds will produce much better results than a portfolio containing about ten funds that invest in the same 20 stocks.
Before opening the next fund, dedicate ten minutes to checking whether there are overlaps between your current investments and your prospective investments.
Frequently Asked Questions (FAQs)
How much overlap is okay in mutual funds?
For stock mutual funds, an overlap of less than 25% to 30% is typically seen as healthy and appropriate.
What is the 7 5 3 1 rule in SIP?
7-5-3-1 rule is a behavioral pattern that serves as a guideline for investors using SIP in equity mutual funds for the long term. The rule is not a regulatory guideline set out by any regulatory body such as SEBI, but a means of remembering how one should invest.
What does it mean when mutual funds have portfolio overlap?
When two or more mutual funds in your investment portfolio own the same underlying stocks, bonds, or other instruments, this is known as mutual fund portfolio overlap.
What does it mean when mutual funds have portfolio overlap?
When two or more mutual funds in your investment portfolio own the same underlying stocks, bonds, or other instruments, this is known as mutual fund portfolio overlap.
What is a good fund overlap?
For equity mutual funds, a “good” or acceptable fund overlap is typically less than 30%, which means that two funds share less than one-third of the underlying stock holdings.