The mutual fund industry has several mutual fund schemes spread across multiple categories. It may be difficult for you to pick suitable mutual fund schemes for optimal portfolio diversification. Diversification spreads your investment in various asset classes to minimise risk in your portfolio. However, diversification doesn’t help you in case of portfolio overlap. How can you avoid mutual fund portfolio overlap?
What is portfolio overlap?
The overlapping of stocks in mutual fund schemes is called portfolio overlap. For example, there are multiple mutual fund schemes under the large-cap category. If you keep adding mutual fund schemes under the large-cap category, you will own the same stocks across funds called portfolio overlap.
You may follow the diversification strategy to minimise risk in your portfolio. However, if you invest in shares of 10 different companies in the same sector, your portfolio is vulnerable to sector-specific risk.
Suppose you invest in mutual funds that belong to different categories like large-cap and Flexi-cap mutual fund schemes. There are chances that the large-cap and Flexi-cap schemes of the same fund house may have many common stocks.
Large-cap funds invest primarily in companies of large market capitalisation, and Flexi-cap funds take exposure to stocks across market capitalisation. However, if there is a portfolio overlap, you will lose the diversification benefit.
How to avoid portfolio overlap?
You could avoid investing in multiple mutual fund schemes of the same category to avoid portfolio overlap. It holds especially for large-cap mutual fund schemes, which, per SEBI rules, invest 80% of their assets in equity instruments of large companies.
However, you will find the portfolio of large-cap funds having a similar composition to the portfolio of stock market indices like Nifty 50 and BSE 100. It makes it difficult for large-cap schemes to outperform these stock market indices.
You could compare mutual fund schemes in your portfolio and determine their exposure to different sectors. For instance, you could avoid investing in two or more mutual funds with similar sector allocations.
It helps to diversify your portfolio across mutual fund schemes of different Asset Management Companies (AMCs) and fund managers. For example, mutual funds managed by the same fund manager could have a common investment strategy. The fund manager may have similar views towards sectors and stocks, which they would follow across their mutual fund schemes. Hence, you could limit exposure to a single AMC or fund manager in your mutual fund portfolio.
Depending on your risk tolerance, you may consider investing in equity mutual funds with exposure across large-cap, mid-cap, and small-cap stocks. Moreover, check the underlying portfolio of mutual fund schemes for the same set of stocks to avoid portfolio overlap.
You could diversify your portfolio with three or four mutual fund schemes in the right proportion that follow different investment strategies. Moreover, diversify your portfolio across asset classes such as equity, fixed income instruments, commodities etc., as no asset class outperforms all the time.
Investing in many mutual fund schemes will not diversify your holdings if the portfolio overlaps. You must check your mutual fund portfolio regularly and rebalance if portfolio overlap exists. Finally, invest in mutual funds based on your investment objectives and do not over-diversify your portfolio with too many mutual fund schemes.
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