Does the overlap of underlying portfolios matter in the case of mutual funds?

Rakesh, an early starter, began investing in his 20s. Many years back, he had attended an investment workshop for retiring early, learning the importance of diversifying one’s portfolio. 

Armed with this insight, he started a SIP in seven different equity funds.

He believed that these seven funds would offer a reasonable amount of diversification. As a result, the portfolio grew reasonably well over the past decade, beating inflation and, more often than not, the benchmark Nifty 50.

However, with the onslaught of the COVID-19 pandemic, the stock market started correcting. So it came as a shocker that his fund portfolio was also falling in proportion to the market fall. “Wasn’t the diversification supposed to provide downside protection, as advised by the investment experts?” he wondered.  

Diversification can’t eliminate Market risk

First, diversification when restricted to a single asset class need not eliminate the market-oriented risk in your equity portfolio. If the stock market goes down, your portfolio will likely fall to the extent of the equity exposure in your portfolio. While a good equity fund manager can cushion this downfall, seldom can they go against the tide.

Let’s get a grip on the portfolio overlap factor

Also, investors need to get a grip on the overlap factor. For example, suppose you are investing only in equity index funds that track a single index, then your portfolio overlap should be 100%.

That’s because all the funds invest in the same stocks and the same proportion as the index under consideration.

However, if you are investing in actively managed funds, the portfolio overlap varies. Many free online tools help you gauge the extent of portfolio overlap in the underlying fund portfolio. 

For instance, portfolio analysis of two top-rated large-cap funds showed a 67% overlap. There were at least 26 stocks that were common in their portfolio.  It was relatively lower for other equity fund categories – Flexi cap (8%), ELSS (13%), Mid cap (16%), and smallcap (17%). 

A smaller investable universe (of about 100 stocks) for large caps compared to other fund categories is mainly responsible for the difference in the overlap figures. Midcap and smallcap funds also held relatively more stocks in their portfolio.

So, whenever there is a significant overlap in the underlying fund portfolio, they tend to move in the same direction. So, should investors like Rakesh be bothered with this overlap factor? Not really.

First of all, understand that the portfolio overlap factor keeps changing frequently. While fund portfolio details are revealed monthly, it keeps changing dynamically. So, when you realise that there is a portfolio overlap, the nature of holdings may have changed. Moreover, if a particular stock or sector is attractive, it’s bound to find buyers. If that results in substantial portfolio overlap, so be it. 

An investor should instead focus on the outcome of the portfolio management activity. That is the fund’s consistency in beating its benchmark and how the fund managers stack up among their peers. However, this is only one factor. Selecting a fund is about analysing multiple factors such as how much risk it takes, its size, its age and many more such factors. Thus it makes sense to check with an advisor before adding a fund to your portfolio.

As long as your funds are in the top quartile of performance and keep beating the benchmark (among other things), you need not worry about the portfolio overlap factor.

Link portfolio to goals

Each set of mutual fund portfolios should ideally chase a financial goal and be in sync with the asset allocation strategy that guides your overall wealth creation. So, keep the investment simple and choose the type of equity funds based on the intended asset allocation.

For example, large-cap, large and mid-cap and Flexi cap funds are all that you might need to construct an equity portfolio.

Diversifying across market capitalisation might also provide some downside protection and return potential.

In essence, prudent diversification is largely about being in multiple asset classes keeping in mind your risk profile and goals.

What’s Prudent diversification 

Every mutual fund house has an investment style and philosophy. Some are aggressive in their portfolio making, while others are conservative.

So, while investing in different sub-equity asset classes, ensure you are not investing all in a single or two fund houses. Also, ensure the fund selection reflects the asset allocation you need to meet your goals rather than any specific fad or unnecessarily complicated idea. 

So what’s the ideal number of equity funds to hold? 

Many experts agree that a maximum of five-eight funds spread across different fund houses is sufficient. Over diversifying can make portfolio management difficult and impact portfolio growth. However, your goals and how much you want to invest can change this number. Remember, though, that investing Rs 10,000 versus investing a lakh will require different approaches to the number of funds you need.

Takeaway