How can you reduce portfolio overlap in mutual funds?

Many investors buy multiple equity schemes without the knowledge of significant potential portfolio overlaps, largely negating the diversification intent. While it is not possible to eliminate overlaps completely, there are ways and means to reduce their likelihood and reach the diversification goal.

What does portfolio overlap in mutual funds mean?

An equity mutual fund scheme invests in a portfolio of stocks in line with regulatory guidelines. So, a large-cap fund will invest at least 80% of its portfolio in stocks ranked 1-100 by market capitalisation, while a mid-cap fund has to put in at least 65% in stocks ranked 101-250 by market capitalisation. Many investors may put money in two or three large-cap funds of different fund houses thinking they are diversifying. However, in reality, a large chunk of your money would be invested in the same set of underlying stocks. For example, all the funds may hold the same large banks, IT companies and diversified conglomerates. This is called portfolio overlap.

Why does portfolio overlap happen in the case of equity mutual fund schemes?

One of the reasons for portfolios to overlap is Sebi’s regulatory guidelines, which specify where a particular category of mutual fund scheme — be it large-cap, mid-cap, smallcap and multi-cap funds — can invest. So, a mid-cap fund needs to invest at least 65% in stocks ranked 101-250 by market capitalisation. Since this universe is limited, there are bound to be overlaps between schemes. Wealth managers point out that portfolio overlap can also happen if you have funds from the same fund house. All AMCs have a style, method and philosophy of building portfolios and it is possible that a set of stocks that they buy in a large-cap fund will overlap with those in the flexicap, multi-cap, value or focused schemes of the portfolio.

How can you reduce portfolio overlap?

While it is not possible to eliminate overlaps, investors should try to keep it as low as possible to ensure diversification. One of the ways to reduce portfolio overlap is to diversify investments across fund categories. When you invest in funds from different categories, the probability of portfolio overlap also reduces as the stock universe changes. For example, you can allocate 60% of your corpus to a largecap fund, 20% to mid-cap and small-cap funds and 10% to a sectoral fund. Another way to avoid portfolio overlap due to the investment style of a fund house is to invest in funds from different AMCs. This will also help diversify the portfolio.