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Riskless investments offering high returns are not often available in the market.
So, how do investors manage their risks and yet earn good returns?
The key is to use various strategies available for mitigating risks. Portfolio diversification is one of the primary strategies to manage risks.
Mutual fund overlap is a situation that contradicts diversification. Read further to know how this impacts an investor’s portfolio.
Mutual funds
The concept of mutual funds (MF) is well known today.
Mutual funds are companies that collect money from investors, pool them together and invest them across various securities available in the market.
These funds are managed by professional managers who intend to help investors achieve their financial goals with respect to risks and returns.
The primary reason for investors to choose mutual funds over regular trading is the diversification it offers.
Mutual fund portfolio
In the financial world, a portfolio is a basket of different kinds of assets.
Investors today prefer to spread their investment across different funds rather than investing the entire sum into one fund.
The purpose of maintaining a portfolio is to have a balance between risks and returns.
For example, one fund may offer high returns but may be risky. Another fund with low risk but stable income will balance this out.
So, investors create their mutual fund portfolios upon assessing their financial capabilities, risk tolerance and investment goals.
What is mutual fund overlap?
When an investor holds a portfolio of mutual funds where a large portion of funds are invested in similar kinds of assets, it creates a situation of mutual fund portfolio overlap. The primary objective of mutual fund investments is to divert the risk. But, MF overlap is a situation that contradicts this idea.
For example, an investor invests in 3 different mutual funds, and all the mutual fund managers invest these funds into the top 3 IT firms in the market.
Causes of portfolio overlaps
The two main reasons for mutual funds to overlap are:
- SEBI (Securities and Exchange Board of India) guidelines to mutual fund companies. The SEBI has laid down the guidelines regarding investments by mutual fund companies.
Large-cap funds must invest in companies with large capitalisation. The mid and small-cap funds must invest in companies with similar market capitalisation. So, the funds are exposed to similar kinds of stocks, leading to identical investments. - Overlaps can occur when an investor invests in different funds handled by a single asset management company. The overlap happens because the objective and thought processes of the AMC managers might be similar and in line with the company’s vision, which may lead to choosing similar securities for investments.
Impact of mutual fund portfolio overlap
- Overlap in mutual funds goes against their main goal. Investors choose mutual funds for a diverse mix of investments to balance risk and returns. Overlap, however, means putting too much into similar assets.
- When portfolios overlap mutual funds, investors face big losses. If a stock’s value drops and many funds hold it, the loss affects all those funds, reducing the portfolio’s overall value.
- Portfolio overlap in mutual funds leads to paying fees for similar stock management across funds, making investment costs unnecessarily high.
- Overlaps lead to the trading of similar stocks in the market. Since mutual funds mostly deal with bulk quantities, the overlap impacts the liquidity and prices of stocks.
Strategies to manage the risk of MF overlap
- Prevention is better than cure. So, it is ideal to read through the fund’s objectives before investing. Investors should avoid investing in funds that offer similar schemes and objectives.
- Investing in funds handled by different asset management companies may help in avoiding overlaps. Although overlaps are still possible, the probability reduces.
- Investors should regularly check their mutual fund portfolios, using online mutual fund overlap tools to spot overlaps and take action if needed, despite professional management.
Types of mutual funds available to mitigate overlap risks
Diversification is the core objective of mutual funds. To reap better benefits, investors must make sure that they choose a diverse range of mutual funds to invest in.
Rather than investing all the money available into one kind of fund, the investors must try to strike a balance between these three kinds of mutual funds:
- Equity funds – These funds pool money from investors to invest in equity shares of different companies.
- Debt funds – These funds are invested into various debt instruments offered by corporations and the government.
- Balanced funds – These funds invest in both equity and debt instruments.
Bottomline
Mutual fund overlap is an unintentional occurrence in most cases. However, it is indeed one of the major risks associated with investing through mutual funds.
Mutual fund companies promptly mention the disclaimers about the risks involved. So, it is the responsibility of investors to ensure their investments are going towards the correct avenues.
Generally, mutual funds disclose all the details of the securities they invest in. It is of extreme importance for investors to study this thoroughly to assess if the mutual fund’s schemes are in line with the investor’s financial goals.
FAQs
To avoid mutual fund overlap, diversify by investing across different types of funds and sectors. Choose funds with varied objectives and managed by different asset management companies to reduce similarities. Regularly use online tools to monitor for overlaps and adjust your portfolio accordingly. Understanding the specifics of each fund and its holdings is crucial for maintaining a balanced and risk-mitigated investment strategy.
Fund overlap occurs when a mutual fund portfolio invests heavily in similar assets across different funds, contradicting the goal of diversification. This redundancy can increase risk and reduce the efficiency of managing risks and returns. Overlaps might happen due to regulatory guidelines or when funds are managed by the same company, leading to investments in identical stocks. It undermines the primary advantage of mutual funds: spreading risk through a varied mix of investments.
Yes, there are online mutual fund overlap tools available. These tools help investors identify and assess the extent of overlap within their mutual fund portfolios. By inputting the funds they are invested in, investors can see how much their investments overlap in terms of holding similar assets. This insight is crucial for taking action to ensure diversification, minimise risk, and align investments with financial goals. Regular use of these tools is recommended as part of a proactive investment strategy.
In mutual funds, the aim should be to keep overlap as minimal as possible. While a certain degree of overlap is inevitable, especially within funds that target specific sectors or regions, the goal is to ensure it remains low. This helps in preserving the benefits of diversification. Excessive overlap can lead to concentrated exposure in similar assets, which contradicts the primary purpose of mutual funds: spreading risk across a wide array of investments.
To address portfolio overlap, begin by using online tools to identify any overlaps in your mutual fund holdings. Each fund in your portfolio should have a unique objective and focus, whether it’s on different sectors, asset classes, or geographical areas. Opt for funds managed by various companies to minimise identical investment strategies. If overlaps are found, consider replacing them with funds that provide better diversification. Regularly reviewing and adjusting your portfolio is crucial for maintaining optimal diversification.