What is mutual fund overlap and how is it a concern?

Before we get to mutual fund overlap, let us tell you the story of Mrs Sharma, who was stocking her pantry with various pre-made spice blends to simplify her cooking. Here is what she did:

Spice Blend 1: "Indian Curry Powder" contains turmeric, cumin, coriander, and chili powder.

Spice Blend 2: "Taco Seasoning" contains chili powder, cumin, paprika, and oregano.

Spice Blend 3: "Chili Powder Blend" contains chili powder, cumin, and garlic powder.

Why are we discussing spices in a mutual fund article? Now, replace each spice blend with a mutual fund and individual spices with individual stocks or assets held by the fund. You will notice that chili powder and cumin appear in all three blends. It is a mutual fund overlap. Let us understand in detail.

What is Mutual Fund Overlap?

Mutual fund overlap occurs when two or more mutual funds in an investor's portfolio have similar holdings, leading to redundant exposure to the same stocks or securities. This reduces the diversification benefit of holding multiple mutual funds.

Here is an example - SBI Bluechip and Kotak Bluechip funds. Let us look at the top holding of both these funds. As you can see here, the top three holdings in the SBI Bluechip fund are HDFC, ICICI, and Infosys.

The same three companies are top holdings in the Kotak Bluechip fund too. You can compare mutual funds and find their other holdings, and you will there is a great deal of overlap.

Why is overlap a concern?

Mutual fund overlap can undermine the core principle of diversification, which aims to spread risk across various assets. Let us look at some reasons why it is a concern:

Reduced Diversification

Diversification reduces portfolio risk by investing in a wide range of assets. Overlap concentrates investments in the same stocks, exposing the portfolio to the specific risks of those stocks or sectors.

Example of Mutual Fund Overlap:

Investor A holds two funds:

Fund X: Rs 10,00,000 invested, heavily invested in technology.

Fund Y: Rs 10,00,000 invested, diversified across sectors.

Top Overlapping Holdings:

Here is what you should note:

• In a portfolio of Rs 20,00,000, technology stocks make up Rs 6,10,000 (30.5% of the portfolio).
• If the tech sector underperforms (e.g., due to regulatory changes or global economic slowdown), the portfolio suffers significantly.

Without overlap, technology might only represent 10-15% of the total portfolio, cushioning the impact of sector-specific risks.

Higher Correlation

If overlapping funds hold similar stocks, their returns will move similarly, reducing the overall portfolio's risk mitigation.

Hidden Costs and Redundancy

Investors often assume that holding more funds equals better diversification. However, overlapping funds lead to redundancy, meaning you are paying for similar exposures multiple times.

Example: Investor A holds:

• Fund U: Rs 3,00,000 (Expense Ratio: 1.2%)
• Fund V: Rs 3,00,000 (Expense Ratio: 1.5%)

If 70% of the portfolios overlap, the investor pays overlapping fees of Rs 2,10,000. This redundancy means the investor is paying higher costs for no real diversification benefit.

How to Identify and Reduce Overlap?

Let us now look at how you can identify overlap for your portfolio:

Step 1: Use Online Tools

You can use online platforms for overlap analysis. These tools allow you to input your mutual funds and generate a detailed report highlighting overlapping holdings. Steps to Use These Tools:

• Input the names or ISINs of your mutual funds.
• View the percentage overlap between the funds.
• Analyze the stocks or sectors contributing to the overlap.

Step 2: Manually Compare Fund Portfolios

• Download the factsheets of the mutual funds or open the mutual fund on ICICI Direct.
• List the top 10-20 holdings of each fund. You can find these details on ICICI Direct.
• Check for common stocks, their percentage allocation, and sector weightage.
• Calculate the combined exposure to overlapping stocks.

Step 3: Sector and Style Analysis

Use tools to identify whether funds are biased toward a particular investment style (e.g., growth, value) or sector. Assess the weightage of sectors (e.g., financials, IT, healthcare) to ensure no unintended sectoral concentration.

Next, let us look at how you can reduce the overlap. Here are a few things you need to do:

• Consolidate Funds with High Overlap: Instead of holding multiple funds with similar holdings, consolidate them into a single, high-performing fund in that category.
• Diversify Across Market Caps: Invest in funds with different market cap focuses (e.g., large-cap, mid-cap, small-cap). This reduces the chance of holding the same stocks, as large-cap funds primarily focus on blue-chip companies, while mid- and small-cap funds focus on emerging companies.
• Diversify Across Fund Categories: Choose funds from different categories that focus on varied strategies or geographies.
• Monitor Overlap Regularly: Analyze fund portfolios quarterly, as fund managers frequently change their holdings. Reallocate funds to maintain diversification and reduce overlap.

Conclusion

Mutual fund overlap reduces diversification, increases concentration risks, and leads to inefficiencies in cost and returns. By identifying and managing overlap, you can build a more balanced, diversified portfolio and optimize risk-adjusted returns.