Karunesh Dev is a former banking professional turned writer and personal finance educator. He offers coaching, financial literacy advisory and a blog on investing wisely and building wealth. He blogs at Investment Diaries with the aim of making people ‘financially literate’ so that they can make smart and intelligent choices. You can reach him here.
What is Fund Overlap?
When a portfolio comprises of multiple equity mutual fund schemes which have similar objectives and benchmarks, it would have many of the same securities. This is an overlap. This happens when most of your mutual funds are investing over and over again in similar stocks within the same or different categories.
The basic idea behind diversification is to invest in different assets so as to decrease the risk associated with a particular asset. If all or most of your funds are buying into the same securities or companies, your purpose of diversification and return maximisation is defeated.
Checking for Fund Overlap
1/ Go through your Mutual Fund portfolios – check the composition of securities in a particular Mutual Fund against the benchmark and peers. Reading through a portfolio is not difficult.
A very simple and effective way is to check the top 5-10 holdings and their weight. For example, if two funds from your portfolio have HDFC Bank, RIL, TCS, Infosys and ICICI bank as top holdings with about the same holding percentage, it makes sense to look for a different fund. (This is just an example and no recommendation)
2/ Look for exposure to a specific sector – for example banking, IT, FMCG, Automobiles etc. If you think two or more funds in your portfolio have an overexposure and in a similarly high proportion, it would be better to look for another fund or assess the risk basis your outlook and return expectation.
3/ Check for the Fund Manager’s style and affinity for a few companies/sectors which might appear repeatedly in all the funds being managed by him/her. There might be a huge overlap in a large cap & multi-cap or a focussed fund being managed by this manager.
4/ The extent of overlap can be checked by using a statistical tool called R-squared. It measures an investment’s correlation against its benchmark.
As per Investopedia,
“R-squared values range from 0 to 1 and are commonly stated as percentages from 0% to 100%. An R-squared of 100% means that all movements of a security (or another dependent variable) are completely explained by movements in the index (or the independent variable(s) you are interested in).
In investing, a high R-squared, between 85% and 100%, indicates the stock or fund’s performance moves relatively in line with the index. A fund with a low R-squared, at 70% or less, indicates the security does not generally follow the movements of the index.”
The index is the benchmark, like Nifty 50, S&P BSE 100 and Nifty Midcap 100 with a base value of 100. Suppose a mutual fund benchmarked against Nifty 50 has R-Squared of 97. This means that the fund is almost a replica of its benchmark and thus imitates the benchmark’s movements.
Why is a high overlap not beneficial?
While some overlap would always be there and is desirable, holding 2-3 similar funds with a high R- squared would not help. High overlap exposes your portfolio to a sector or a company-specific risk. It limits the portfolio returns when compared with the benchmark.
The very purpose of investing in actively managed funds is to beat the benchmark returns.
Investing in too many mutual fund categories or across Fund Houses (AMCs) does not necessarily mean that you are diversifying. It does not ensure superlative returns.
An ideal portfolio should not have more than 5-6 funds with a mix of different categories and/or Fund Houses-one fund from the large-cap space, one from mid-cap, one from small-cap and one from the multi-cap space is all that you need. ELSS should be part of the portfolio from a tax saving perspective.
Fund overlap is only one of the several factors that you should look into. A better understanding can be developed once you start investing and then by monitoring your portfolio periodically.
Kuvera: we recommend a 5 fund portfolio with little or no fund overlap. You can check it here.