Mutual Fund Overlap: Risks & Fixes

Mutual funds are investment vehicles that collect money from numerous investors to buy a basket of stocks, bonds, and other securities. That means one mutual fund can invest in dozens or even hundreds of individual securities. Hence, it is not unusual for investors to hold shares in several mutual funds. This creates the potential for mutual fund overlap when two or more funds held by an investor have some of the same securities.

Mutual fund overlap is not good or bad in itself. It is something that has implications that the investor needs to be aware of. This article discusses what mutual fund overlap is and the risks and benefits involved with having overlapping funds in your investment portfolio.

What is Mutual Fund Overlap?

Mutual fund overlap refers to a situation where two or more funds owned by the same investor contain some of the same securities.

For example, Fund A and Fund B both invest heavily in information technology stocks. As an investor, you own shares of both Fund A and Fund B. In this case, there is overlap between the funds because you hold many of the same stocks.

The extent of overlap can range from minimal to almost complete duplication of holdings. Two funds tracking the same market index would have nearly 100% overlap. On the other hand, two actively managed funds in the same sector may have only partial overlap based on the specific stocks the managers choose to buy.

Causes of Mutual Fund Overlap

• Investing in multiple funds tracking the same benchmark index. For example, owning shares in three different funds that all track the Nifty 50 index would lead to very high overlap.

• Owning several actively managed funds in the same sector. For instance, investing in three different large-cap growth mutual funds often results in overlap because the managers gravitate towards the same types of stocks.

• Using a fund-of-funds approach. Funds-of-funds hold shares of other mutual funds. This structure inherently leads to some amount of overlap.

• Receiving advice to diversify across fund families. Some advisors recommend owning funds from different companies to diversify. But this can still result in overlap if the funds invest in similar securities.

• Not paying attention to underlying holdings. Some investors pay more attention to fund names, categories, or past performance than the actual stocks and bonds held within each fund. This lack of visibility can inadvertently lead to overlap.

Potential Risks of Mutual Fund Overlap

Concentration risk: Overlapping funds may result in overconcentration in certain securities, sectors, or asset classes. For example, owning several large-cap tech funds could leave you overexposed to a single sector.

Reduced diversification: The core benefit of mutual funds is instant diversification – exposure to dozens or hundreds of different stocks or bonds. But overlap between funds decreases overall diversification in a portfolio.

Lower return potential: Owning overlapping funds may hinder returns rather than enhance them. If several funds own the same stocks, those holdings are simply being duplicated rather than being truly diversified across more opportunities.

Higher investment costs: Funds charge expense ratios to cover costs of management and operations. If multiple funds own the same securities, you may pay unnecessary costs for effectively owning the same stocks multiple times over.

More difficult rebalancing and asset allocation: Rebalancing a portfolio and maintaining target asset class exposures becomes more complicated when funds overlap. It is harder to shift money between different parts of the market without unintentionally changing allocation.

Possible Benefits of Limited Overlap

Alternative perspectives: Actively managed funds with managers who have different investment philosophies may own some of the same stocks, but for different reasons and with different weightings. This can provide an additional perspective.

Round lot shares: Mutual fund managers may buy round lot shares of stocks (in increments of 100). If you own multiple funds with small position sizes in the same stock, the combined holdings may equate to a round lot position even if the individual funds only own odd lots.

Mitigate timing risks: If rebalancing a portfolio with new cash flows, having some amount of overlap can help mitigate the risk of unintentionally market timing when new purchases do not align perfectly with sales in other funds on the same day.

Avoid disruption from fund closures or manager changes: If a single fund closes or a manager leaves, overlapping funds can provide continuity of exposure so a holding does not need to be eliminated entirely.

How to Identify Mutual Fund Overlap?

Determining the extent to which mutual funds overlap in their holdings requires checking the underlying securities within each fund. This information can be found in a couple of places.

Fund prospectus: The prospectus for each mutual fund provides a full listing of the fund's holdings, typically updated on a quarterly basis. You can compare the holdings listed in prospectuses to identify overlap.

Fund fact sheets and websites: Mutual funds periodically publish fact sheets and update their websites showing their current top ten or top twenty holdings. While not as comprehensive as the prospectus, these listings can give a general sense of overlap.

Third-party mutual fund analysis sites: Many websites allow for side-by-side comparison of mutual fund holdings and provide numerical overlap statistics showing the percentage of duplication between two funds.

How to Reduce Mutual Fund Overlap?

1. Identify core holdings Build a consolidated list of all securities held across overlapping funds. Identify which holdings represent 'core' long-term positions to retain.

2. Eliminate extra funds Eliminate redundant funds that mostly duplicate positions already held in your core funds. Consolidate overlapping assets into fewer funds.

3. Prioritise index funds For broadly diversified market exposure, use index funds rather than overlapping actively managed funds. Index funds minimise overlap by design.

4. Choose complementary active funds For active funds, choose managers with complementary (not duplicative) strategies. Seek differentiated exposures rather than more of the same.

5. Check new purchases Before buying any additional funds, thoroughly check holdings to avoid reintroducing overlap into the portfolio.

Understanding if and when mutual fund overlap is excessive allows investors like you to structure their portfolio in the most efficient manner. Following best practices for identifying and addressing duplication can help maximise diversification and returns from a mutual fund portfolio.