Last Updated on July 16, 2021 at 8:10 am
I get this kind of question a lot: There is a 30-40% overlap in the portfolios of my mutual funds. Is this okay, or should I change my funds? How much of a portfolio overlap is OK, and how much is not? A discussion.
The reasoning presented here is similar to the one discussed before: Can I invest 50% in index funds and 50% in active funds? The answer depends a lot on the context; on the intention behind the constructed portfolio.
Suppose I start investing in the UTI Nifty Index Fund Direct Plan in two separate folios. There is obviously a 100% overlap of stocks between the two folios. Is there anything wrong with doing this?
Maybe we could assign one folio to one goal and another to another. What if we use both the folios for the same goal? Is there anything wrong with this? It is unnecessary for sure, but there is nothing terribly wrong with it. Both folios have the same expense ratio and the same returns.
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In this case, we do not worry about the percentage overlap but question the decision to open a second folio if it will be used for the same goal. We should adopt the same approach to evaluating the portfolio overlap among our mutual funds.
If our portfolio has two funds, say A and B, the primary question to ask is, why did we choose these funds? Suppose these two funds are from the same category? Many investors would rush to point out that it is bad to buy two funds from the category. Age has taught me that it depends.
If a person is going to start a SIP of Rs. 1000 in two large cap funds is this a good idea or a bad one from the perspective of portfolio overlap (let us leave out active vs passive here, please)?
If the person is new to mutual funds and scared to commit all his investments with one fund house and therefore chooses two funds, it is reasonable. The problem is we have people who start a SIP of Rs. 1000 in a 5/6 mutual fund from day one, and all of them are either from the same category or from overlapping categories (e.g. large cap and large+midcap).
Is there anything wrong with this? That many funds from day one for that investment seem unnecessary. The portfolio would soon be tracking the index at a higher management fee. Other than this and the possibility of increasing clutter in the portfolio (that 5 funds could soon become 45 funds), there is nothing wrong with it!
We cannot be dismissive of a portfolio of several funds without appreciating context though. Suppose a person holds six large cap funds, it may seem like a bad idea at first sight but that person could be 50+ with each fund value above one crore. The person may not be comfortable with putting much money in the same fund house. And at six crores, “tracking the index at a higher management fee” is a far better thing to do than investing part of it in a PMS.
So two things are important to determine if a “large overlap” in stocks between funds is acceptable or not: reasonable context and clear intent. We have looked at the reasonable context above.
For clear intent suppose the funds’ A and B are a large cap and mid cap fund respectively. One would expect the overlap to be minimal as the purpose of each fund is different and this is an example of a well-diversified portfolio.
However, this does not mean the overlap is always minimal. A can invest in about 15% of mid caps and B can inevst in about 30% of large cap stocks. So the overlap could be about 40%. This however will not be permanent. There is nothing wrong if this happens as it is beyond the control of the investor. The intent behind the portfolio construction is correct and that is all that anyone can do.
It is only rarely one would have a diversified portfolio with “zero-overlap”. For example, if they inevst in the NIfty and Nifty Next 50 index funds.
If the portfolio has funds with distinct investment mandates, investors need not worry too much about portfolio overlap. Trouble arises when they start with a large cap fund, add a large and mid cap fund, then a flexicap fund, then a multicap fund, then an aggressive hybrid fund.
Obviously, the overlap would be high in this case, but the root cause of the problem is a muddled approach. Many investors (including yours truly) investment portfolio is a collection of mistakes rather than what it should be – a collection of diversified entities.
If investors build a portfolio with a clear intent and reasonable context, they do not have to worry about portfolio overlap. Some examples of this are:
- NIfty or Sensex
- Nifty + Nifty Next 50
- Nifty 100 (other index funds are ETFs have huge tracking errors)
- large cap + mid cap funds
- flexi-cap fund
- large and midcap fund
- multicap fund
- aggressive hybrid fund
For small portfolios, one of each is enough. For larger portfolios, one or more funds of the same type can be added (reasonable context).
In summary, we recommend investors first focus on building a portfolio with distinctly different entities – that is funds with different investment mandates. If this is in place, they can ignore the portfolio overlap between their funds as it is not in their hands. Of course, using index funds can achieve all this and more in the easiest way possible. Active funds or passive funds, a strong conviction in our choices and the discipline to stay the course is essential.
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