What is mutual fund portfolio overlap and how to avoid it?

Diversification is believed to be the cornerstone of a successful investment strategy. However, as is the case with most things in life where balance is the secret ingredient for achieving perfection, diversification too has to be maintained at optimum levels.However, despite investors understanding the importance of achieving the right level of diversification in their portfolios, figuring out the exact math behind it and gauging which combination of instruments will achieve the desired results can be hard for seasoned investors and novices alike.In this regard, mutual funds have won the favour of a large coterie of retail investors. The gamut of mutual fund investing is such that diversification objectives are comparatively easier to meet as compared to stitching together a portfolio comprising separate asset classes. The array of mutual funds has something for everyone and for a wide variety of investment horizons and goals.However, with mutual funds too diversification can be tricky to decode. For example, you may buy shares of five different companies and this would minimize your company-specific risks but if all or most of the companies in this selection belong to the same industry or sector, you would be overly exposed to sector-specific risks.What is portfolio overlap?This kind of overlapping of stocks in mutual fund schemes is a common pain point that emerges in the journey of many mutual fund investors. Mutual fund portfolio overlap occurs when you invest in different schemes, but there is a large degree of similarity in the underlying portfolio constituents. Investing in mutual funds with the same holdings could lead to a concentration of risk in your portfolio and this may be counter-productive and make the benefits of diversification non-existent.Deepak Chhabria, CEO of Axiom Financial Services says, “The objective of portfolio diversification is to reduce risk in the portfolio. Some risks like systemic risk cannot be avoided, but diversification can help in mitigating the risk involved in investing. Overlap occurs when there is a concentration of investment in sectoral or thematic funds, this can also happen in diversified funds if the investment schemes have exposure to the same set of stocks, though the extent may differ.”For example, if you invested in multiple mutual fund schemes under the large-cap category there is a very high chance you will own the same stocks across funds. Similarly, if you have invested in large cap and flexicap funds, you may have some stocks in common because flexi cap funds invest in stocks across all market capitalization segments.How to avoid portfolio overlapWhile diversification does not guarantee the prevention of loss, it is paramount in minimising losses in the long term. Through diversification, the entire portfolio does not get plunged into risky territory even if one asset class performs below expectation. In order to avoid overlap, investors should refrain from investing in too many schemes of the same category. This is especially true in the case of large-cap funds because especially in the case of large-cap funds because as per SEBI’s regulations, a large-cap fund has to invest at least 80 percent of its assets in large-cap companies, which are ranked 1st to 100th on Indian stock exchanges in terms of market capitalisation. Thus the investible pool, in this case, is much smaller which leaves little room for portfolio managers to diversify strategies. Checking sectoral allocation can also help you sidestep excessive exposure to a certain sector which can amplify risks. Chhabria says, “In mutual fund investing it’s important to ensure that the investor is not taking undue risk by investing in similar schemes and with the fund managers that have the same investment style. If the fund managers have similar styles and strategies there is a high chance that they may land up owning the same stocks. The Indian market has a limited universe of good quality stocks, and some degree of overlap is unavoidable. But needs one needs to be aware of the same. Else, on the portfolio level, the exposure to a particular industry/sector or company may be disproportionately high. Constant monitoring of the underlying holding in the schemes should be undertaken on regular basis to ensure the overlap is limited.”Investing in schemes offered by multiple AMCs and different fund managers can also be an effective ruse for avoiding overlap. Funds managed by the same manager would likely reflect a common investment strategy because the manager’s perceptions of sectors and stocks would not be differentiated for different funds. The issue would be the same at the AMC level because the research team involved in drafting strategies of fund management would be the same. Chhabria says, “Overlap can be avoided by ensuring that the investment is with schemes and fund managers who have different investment styles, think differently, and are true to the label. At an investor level diversification can be achieved by investing across market capitalization and sectors. Various schemes are available and, over time the fund manager style also becomes quite apparent. Close monitoring and seeking the guidance of an expert can help.”Action pointsCompare mutual fund schemes in your portfolio and check their exposure to different sectors and industries so that you do not have too many funds with similar sectoral allocations.Based on your risk tolerance, you may consider investing in equity mutual funds with exposure across large-cap, mid-cap, and small-cap stocks.This article is part of the HT Friday Finance series published in association with Aditya Birla Sun Life Mutual Fund.