Portfolio overlap happens when your different mutual funds own the same stocks.Investors often purchase multiple equity schemes without realizing the potential for mutual fund portfolio overlap, which can undermine their diversification efforts. While completely eliminating mutual fund overlap is impossible, there are strategies to minimize its likelihood and achieve effective Portfolio diversification and returns.
Why Does Portfolio Overlap Occur in Equity Mutual Funds?
One reason why portfolio overlap happens is from regulatory guidelines set by Sebi, which dictate the investment universe of various mutual fund categories, such as large-cap, mid-cap, small-cap, and multi-cap funds. For instance, a mid-cap equity fund must invest at least 65% in mid cap stocks ranked 101-250 by market capitalization. This limited universe inevitably leads to overlap between schemes.
Additionally, portfolio overlap can stem from investing in funds from the same fund house. All AMCs (Asset Management Companies) have a distinct style, methodology, and investment philosophy, resulting in potential overlap between stocks held by their large-cap, flexi-cap, multi-cap, value, or focused schemes.
What Does Portfolio Overlap in Mutual Funds Mean?
Equity mutual funds invest in a portfolio of stocks aligned with regulatory guidelines. A large-cap fund, for example, must invest at least 80% of its portfolio in stocks ranked 1-100 by market capitalization, while a mid-cap fund must allocate at least 65% to stocks ranked 101-250 by market capitalization. Many investors may invest in two or three large-cap funds from different fund houses, believing they are diversifying. However, a significant portion of their money could end up invested in the same underlying stocks. For instance, all funds may hold the same large banks, IT companies, and diversified conglomerates. This concentration of investments in a limited pool of stocks is known as portfolio overlap.
How Much Portfolio Overlap is Acceptable?
Having up to a 40% overlap in our portfolio is generally acceptable, but having multiple instances of 40% overlap can increase the likelihood of reducing our returns. While you can check portfolio overlap for free online, most tools only allow you to analyze overlap between up to two funds. However, our own tool allows us to analyze overlap for a larger number of funds.
Just because two funds have a 70% overlap doesn’t necessarily mean that both will underperform. It’s possible that both funds are strong performers in their own categories.
Similarly, having a 20% overlap doesn’t guarantee that both funds will generate returns. In fact, both funds might be underperforming their index.
To ensure that our returns aren’t negatively impacted, it’s important to minimize overlap. Having two underperforming funds with low overlap and having high overlap with one underperforming fund can significantly reduce our returns. Therefore, reducing overlap is key to maximizing our investment returns.
Example of Mutual Fund Portfolio Overlap
If we look at this Live portfolio, we see that there’s a 43.45% overlap between Nippon India ELSS Tax Saver and Mirae Tax Saver. However, while Mirae has performed well, Nippon hasn’t delivered good returns. This means that the entire portfolio’s performance is affected by Nippon’s performance.
Similarly, Aditya Birla and Nippon India ELSS Tax Saver have a 42.92% overlap, but both haven’t performed well compared to its index. One gave a return of 12.12%, and the other 17.30%. Again, having two funds with significant overlap and poor performance dragged down the overall portfolio returns.
Similarly, when we compare the returns of Mirae Asset Tax Saver and Mirae Asset Emerging Blue Chip Fund, we find that they have a 74% overlap. Despite this high overlap, both funds have delivered better returns than their respective index benchmarks.
However, despite the good returns, it’s advisable to have only one of these funds in the portfolio. This is because both funds rely on similar types of stocks within their portfolio. Having too much overlap in holdings can potentially increase risk, and consolidating to one fund can streamline the portfolio while maintaining exposure to the desired market segment.
Similarly, if we examine the overlap between Axis Midcap and Aditya Birla ELSS Fund, we find it’s only 16.13%. However, despite this relatively low overlap, both funds have failed to outperform their respective index benchmarks.
This indicates that the level of overlap alone doesn’t dictate whether our returns will increase or decrease. Instead, the performance of the funds themselves is crucial. Regardless of overlap, having underperforming funds can significantly impact our portfolio returns, whether the overlap is low or high.
How did thid Portfolio Performed with 70% Maximum Overlap?
Since 2019, this client invested in a total of 15 funds until 2024. The portfolio returns have been exceptional at 121%, which is very encouraging for investors.After achieving a remarkable 121% returns in less than 5 years, it might seem like having an advisor is unnecessary and that increasing the number of funds will automatically boost returns. However, it’s important to note that having many funds doesn’t always guarantee superior performance, even if they are rated five stars.
During the same period, the Nifty 500 index delivered a return of 140%, outperforming many of the funds. Initially, the portfolio performed well, likely due to the presence of five-star rated funds. However, after a year, the market experienced a downturn, impacting the overall portfolio performance.
Strategies to Minimize Portfolio Overlap
While eliminating overlap entirely from investment portfolios is not feasible, investors should strive to keep it as low as possible to ensure diversification. One approach to reduce portfolio overlap is to diversify investments across different fund categories. Investing in funds from various categories reduces the likelihood of overlap as the stock universe expands. For example, an investor could allocate 60% of their corpus to a large-cap fund, 20% to mid-cap and small-cap funds, and the remaining 10% to a small cap fund.
To construct a robust portfolio, we should focus on selecting the best and consistently performing funds. Additionally, it’s advisable to ensure that the overlap between any two funds remains below 40% to maximize returns and minimize risk.
