Sumit, a young mutual fund investor in his 20s, started SIPs (Systematic Investment Plan) after knowing the benefits and role of regular, diversified mutual fund investments. He started SIP in five different equity funds to diversify the investment portfolio, which then grew for a few years until the period of the market correction. Much to his surprise, his mutual fund portfolio fell in proportion to the market fall, making him wonder why diversification couldn’t provide downside protection.
Many investors like Sumit may begin their journey of mutual fund investments in this manner. Their lack of knowledge about mutual fund portfolio overlap can keep them attached to wild guesses and unrealistic investment decisions that may eventually hurt in the long run.
If you have heard of the portfolio overlap here for the first time and are on the cusp of investing in mutual fund schemes, you’ve come to the right place.
What is Mutual Fund Overlap?
Before we talk about portfolio overlap, do you know what a mutual fund portfolio means? If not, read this first -
A mutual fund portfolio can be referred to as the collection of securities of different types that a mutual fund scheme has invested in.
A mutual fund portfolio overlap occurs when you invest in one or more different funds that, in turn, invest in the same securities. Like most investors, you would want to diversify your portfolio by investing in various schemes. However, if all the chosen schemes purchase the same type of securities, then the objective of portfolio diversification will not be served.
Here’s a simple example that explains mutual fund portfolio overlap -
You invest in an ABCD mutual fund scheme that invests 10% in the shares of ABC company. If you then invest in an ABCDEF fund that also invests a similar percentage in the shares of ABC company, the portfolio will overlap significantly.
Diversification and Market Risk - How Are They Connected?
It is more like linking the basic diversification analogy with market risk - the more eggs you put in one basket, the more you will lose if that basket collapses.
Diversification, when restricted to one scheme category, does not help reduce the market-related risk in your portfolio. In simple terms, market risk refers to the possibility that you may experience losses due to market dynamics. If the market goes down, the value of your investments will most probably fall in line with their equity exposure.
Should You Be Worried About Portfolio Overlap?
As an investor, you need to grasp the MF portfolio overlap factor. For example, if you invest in index funds, then the mutual fund overlap may be 100%. It is because all the schemes having the same underlying index have investments in the same stocks and that, too, in the same proportion.
You need to understand that the portfolio overlap factor changes dynamically with time. Instead of constantly looking at how the nature of the holdings might have changed, focus on the outcome of portfolio management. It revolves around the consistency of chosen funds in beating their benchmark and the skills of the fund managers. Selecting schemes for mutual fund investments is about analysing multiple factors, such as age, income, etc. Hence, it makes sense to perform detailed research before selecting any funds.
Key takeaway
Ideally, your portfolio should be defined, so that it chases a particular life goal and has the corresponding asset allocation strategy guiding you toward wealth creation. Once you have selected the right type of funds, have an intended asset allocation in mind, and know about portfolio overlap, you will benefit from prudent diversification.
Mutual fund overlap does matter to some extent. But it may not matter as long as the funds you have selected beat their respective benchmarks. After all, what matters at the end of the day is fulfilling your financial goals.
Disclaimer:The information herein is meant only for general reading purposes and the views being expressed only constitute opinions and therefore cannot be considered as guidelines, recommendations or as a professional guide for the readers. The document has been prepared on the basis of publicly available information, internally developed data and other sources believed to be reliable. The sponsor, the Investment Manager, the Trustee or any of their directors, employees, associates or representatives (“entities & their associates”) do not assume any responsibility for, or warrant the accuracy, completeness, adequacy and reliability of such information. Recipients of this information are advised to rely on their own analysis, interpretations & investigations. Readers are also advised to seek independent professional advice in order to arrive at an informed investment decision. Entities & their affiliates including persons involved in the preparation or issuance of this material shall not be liable in any way for any direct, indirect, special, incidental, consequential, punitive or exemplary damages, including on account of lost profits arising from the information contained in this material. Recipient alone shall be fully responsible for any decision taken on the basis of this document.
Mutual Fund Investments are subject to market risks, read all the scheme related documents carefully.
