Have multiple mutual funds? Know how to check overlap

Mutual funds are often marketed as a way to spread risk, but the reality is that many of them share significant overlaps in their holdings. If you own multiple funds, it’s important to check for overlap – the extent to which different funds hold the same underlying stocks. Overlap reduces true diversification as common stocks contribute to your portfolio multiple times. The higher the overlap, the less diversified your portfolio is.

This overlap occurs because fund managers are all working off the same information and investing in similar top companies. For instance, large-cap Indian mutual funds all aim to mirror indices like the Nifty 50, leaving a limited pool of investable stocks. Consequently, fund managers often arrive at the same investment conclusions.

To understand your actual exposure, list out the top holdings of each fund you own, assign their respective weightings, and calculate the percentage of common stocks between them. A modest 30-35% overlap is typical. Over 50%, and you should be concerned, and above 70%, the funds essentially mirror each other. Significant overlap becomes problematic when the common stocks underperform, as losses then get multiplied across your portfolio.

When adding a new fund to your portfolio, it’s wise to compare its top holdings with what you already own. If the new fund’s holdings are very similar to your existing ones, it’s not adding much diversification value. Also, be cautious when combining funds within the same investment category – for example, two large-cap funds or a mid-cap and a flexi-cap fund from the same house often overlap substantially.

However, some overlap across categories, such as an active mid-cap fund alongside a large-cap index fund, is not inherently bad if the funds pursue different investment strategies. The key is achieving meaningful diversification rather than striving for zero overlap.