How to avoid portfolio overlap while investing in mutual funds
Buying the same kind of mutual funds could mean buying the same kind of stocks or even the same stocks. This will lead to portfolio concentration risk.
You have different funds in your portfolio. They are equity funds. However, they are of different varieties Ė one is large cap fund, another thematic fund, one other is a multi-cap fund and another is a mid-cap fund. So, you think you have a diversified portfolio. Is this a right assumption? Not always.
You cannot avoid portfolio concentration risk by just investing in different kinds of equity funds. Why? Because mutual funds might have different names but they could invest in the same stocks. This means you, as an investor, are investing in the same stocks leading to portfolio overlap. There’s nothing wrong with this if you have invested in many funds. However, if you have invested in a few funds, this could be very risky for you.
Your portfolio could have company-specific risk or sector-specific risk. You don’t want your portfolio to be overly dependent on a few stocks, right? Portfolio overlap defeats the whole purpose of diversification. So, here are a few things you should keep in mind to avoid any portfolio overlaps.
Use the style box
A style box is a graphical representation of a mutual fund’s characteristics. This was made popular by Morningstar. The style box is a valuable tool used to determine the asset allocation of the fund. There are slightly different style boxes used for equity and fixed-income funds.
For equity funds, the style box provides the portfolioís investing style that will include value, blend, or growth and the asset-weighted size which are large-, mid-, or small-cap. For debt funds, it represents duration that is short, intermediate, or long and credit quality which is high, mid, or low.
The style box will tell you about your managerís investment style. This will help you avoid investing in same kind of funds. How? For instance, if you look at the style box, you wonít invest in mid cap value funds if you already have such funds in your portfolio. If you already have mid-value funds, try increasing your investments in large-blend or small-value offerings.
Look at the top holdings
Any two mutual funds’ portfolios may look different. However, you need to be aware of whether you hold too much of a particular stock. For instance, letís say you have two large cap funds and both the fund managers may have made outsized commitments to HDFC Bank. This will increase your company-specific risk.
If you invested in only a few funds, you could examine each fund’s top holdings and weights to see if there are investments in a particular company. If you have too many funds in your portfolio, take the help of your financial advisor.
Consider the sectors
Even if you find that you don’t have individual stock exposure, you may still be overexposed to one or two sectors of the market.
For instance, let’s take banking and financial services, a sector that has received a lot of attention in the past decade. Banking has been a wonderful long-term return story. So, fund managers have often invested a lot of money in the banking stocks. However, we know that one of the reasons why the market volatility was so painful for some of us in the past year is because of this industry. Investors were generally more exposed to this sector than they had realized.
Growth funds usually had large banking weightings with lofty prices and even loftier earnings expectations. Mid- and small-growth funds held more than 40 per cent in banking and financial services. More recently, exposures to this sector have declined slightly as managers have realized the risks involved.
So, it’s a good idea to look at your portfolio regularly to make sure that it hasn’t gotten too skewed towards a particular industry.
Donít buy too many large cap funds
Advisors often talk about how large caps are a safe bet. Why? Because large cap stocks are easy to buy and they are pretty simple to understand. However, most large cap funds invest in the same stocks. Most of them might invest in stocks from the Sensex or the Nifty. Understand that the large-cap universe is relatively small. Less than 15 per cent of all stocks can be classified as Ďlarge capí. So, investing in too many large cap stocks could lead to investing in the same stocks. It is important for investors to avoid large-cap addiction, especially large-cap funds from the same fund family.
Donít buy funds run by the same fund manager
Mr. Z is a good fund manager and her funds give great returns. So, you can invest in all her funds, right? Not exactly. Just like everyone has their own style of working, fund managers have theirs. Each manager has a style that they might follow irrespective of the fund they run. For instance, if the fund manager is bullish on a particular stock, she might make sure that that stock is a part of all the funds she manages. So, the investor who invests in all her funds is taking on more stock-specific risk because the percentage of that stock will go up in their portfolio. Imagine investing half of your money in ICICI Bank or Bajaj Auto? You could miss the bull-run in other stocks. Also, when that stock falls, your entire return will get hit. So, even if you are totally in love with a fund manager, stick to buying two of their funds.
Diversification across mutual funds is as important as diversifying across asset classes.