The Indian equity markets have scaled to a lifetime high, and the euphoria is pretty much evident. Giving in to the FOMO (fear of missing out), those who stayed out of equities, too, are now coming forward and participating.

The CDSL and NSDL (the two depositories in the country) data reveals that 31 lakh new demat accounts (noticeably higher than the last couple of months) were added in August 2023, taking the total demat tally to 12.66 crore, 25.83% more than year ago. Similarly, mutual folios touched an all-time high of 15.42 crore versus 13.64 crore, an increase of 13.05%.

Certain sub-categories of equity mutual funds particularly have witnessed remarkable inflows in the lump sum as well as the SIP mode.

But when you are investing in equities to build wealth and accomplish the envisioned financial goals, care should be taken to avoid a portfolio overlap.

What is Portfolio Overlap?

It refers to a situation of duplications of securities in the portfolio. Many a time, the overlap happens unintentionally with the exposure to the same securities through different avenues or mutual fund schemes.

That said, one ought to consciously make certain that the portfolio holdings are well-diversified, i.e., spread across asset classes, securities, and sectors.

A portfolio overlap results in concentration risk and polarises the potential returns. Simply put, it proves counterproductive to diversification. You see, too much of anything is good for nothing.

Mutual Fund Portfolio Overlap

When you invest in mutual fund schemes, their under portfolios may have an overlap with other schemes from the respective category and sub-category. And it’s not just the stocks in the mutual fund’s portfolio but also their composition or weight in the portfolio.

It makes sense for you, the investor, to evaluate this when considering adding a new one.

For example, if you hold multiple schemes within the same category — say largecap mutual funds — it is likely that they have invested in the same set of stocks or follow similar strategies.

By mandate, largecap funds invest the first 100 securities on a full market capitalisation. So, there could be certain underlying securities that could be common across largecap funds. What you need to assess is whether the portfolio composition of the respective scheme under consideration is unique, or else it may result in portfolio overlap, unable to add much value.

Keep in mind that, when two or more mutual fund schemes from the respective category and sub-category have more or less the same securities and are held in almost the same weightage, adding another such scheme defeats the purpose of diversification. Beyond a point, every scheme added to your investment portfolio offers no extra benefit, does not necessarily lower the risk, may cause portfolio overlap, occupy space in the portfolio, and increase the burden of managing it.

A scheme may be added only if it has a unique investment mandate to offer via its strategy and style. Avoid adding a new scheme to your investment portfolio just because the respective category and sub-category of mutual funds have delivered better returns or there is a New Fund Offer (NFO).

It makes sense to assess your risk profile, investment objective, the financial goals you are addressing, and the time in hand to achieve those envisioned goals before adding any scheme and see if it would be a worthwhile addition. Don’t just make investment decisions based on historical returns, which are in no way indicative of the future.

Adding too many mutual funds schemes to your investment portfolio would make it difficult to manage it over time. You may even end up with a portfolio consisting of underperforming schemes and schemes with overlapping investments.

[Read: How to Reduce the Number of Schemes in Your Mutual Fund Portfolio]

How to Check and Avoid Portfolio Overlap?

Well, there are a number of tools online to check if there is a portfolio overlap of two or more mutual fund schemes. All you have to do is select the category and sub-category and then enter the scheme names therein to check.

The online mutual fund portfolio overall tools shall give you a perspective on the number of common stocks, including the percentage of portfolio overlap, the uncommon stocks in Fund A and Fund B, and more.

Ideally, when using the portfolio overlap online tool, for a sensible comparison, care should be taken to compare funds from the respective category and sub-category.

You see, a certain degree of portfolio overlap is unavoidable and therefore acceptable. But if it is remarkably high, such as 65% or more, it may inflict concentration risk. Two mutual fund schemes with a high portfolio overlap may exhibit similar risk-return traits.

Further, mutual fund portfolio overlap is a dynamic concept. Meaning, that it will change as and when changes are made in the underlying portfolio by the fund manager. Thus, when you own mutual funds, it becomes necessary to regularly review the portfolio.

[Read: Why A Year-end Portfolio Review Makes Sense]

Reviewing the mutual fund portfolio periodically by following a prudent approach would not only help you check the portfolio overlap but also assess the performance and the health of your portfolio, which is in the interest of your long-term financial well-being. Watch this video:

If you find that you are holding too many mutual fund schemes and are worried about portfolio overlap, here is how you can optimise your portfolio:

  • Avoid adding a mutual fund scheme to your portfolio just because a friend/relative/colleague has recommended it or because you find the sales pitch of a scheme interesting.
  • Avoid adding more than 1-2 schemes from the same category because schemes within a particular category usually invest in a common set of stocks. For example, largecap funds may easily have a 50% to 70% overlap in their portfolios due to the same universe of top 100 stocks. Similarly, flexi-cap funds, owing to the flexibility to invest across market capitalisations may have a 40% to 60% portfolio overlap, while midcap funds around 30% to 50% portfolio overlap. But smallcap funds, due to a wider stock universe, could have a 20% to 30% portfolio overlap.
  • If you already hold multiple schemes within the same category, eliminate the one that has consistently underperformed its benchmark and the category average over longer time frames.
  • Eliminate those schemes that do not align with your financial objectives and in turn, add to the risk element of your portfolio.
  • Reduce the number of schemes from the same fund house/fund manager, as they are likely to follow similar investment styles/strategies across schemes. The total number of schemes in your entire portfolio, ideally, should not be more than 8 to 10 schemes diversified across categories and sub-categories with unique investment propositions, but those suiting your needs.

If you need help reviewing your mutual fund portfolio, seek the services of a SEBI-registered investment advisor.

A proficient and independent SEBI registered investment advisor re-evaluating your needs and risk profile shall not only help you check the issue of portfolio overlap but also help you recognise…

  • Exposure to market capitalisation segments – large-cap, mid-cap, and small-cap
  • Sector-wise exposure
  • The investment style followed by the underlying funds
  • Your AMC-wise exposure
  • Exposure to various categories and sub-categories
  • The return generated – across time frames and market phases (bull and bear)
  • And the level of risk the mutual fund schemes exposed its investors to

This scientific and comprehensive approach can help you make course corrections in line with your needs.

Here are the ten key benefits of a scientific portfolio review:

  1. It aligns the investments as per your risk profile, investment objective, envisioned financial goals, and the time in hand to achieve those goals
  2. Incorporates changes in your cash flows
  3. Resets the asset allocation within the limits best suited for you
  4. Facilitates portfolio consolidation (doing away with excess number of schemes) and rebalancing
  5. Replaces underperforming mutual fund schemes with better alternatives
  6. Optimally structures and diversifies the portfolio (across asset classes)
  7. Potentially improves the risk-adjusted returns of the portfolio
  8. Ensures adequate liquidity of the portfolio
  9. Ensures wealth creation continues
  10. And make sure you are on track to accomplish the envisioned financial goals

You can’t simply follow a buy-and-forget approach; it does not always pay off. Remember, the old proverb, ‘a stitch in time saves nine’.

How to approach your investments at a market high?

At present, when the Indian equity markets are near a lifetime high, it would be wise to tread cautiously rather than go gung-ho. Avoid committing these eight grave mistakes:

  1. Getting carried away by irrational exuberance
  2. Chasing every IPO and NFO that hits the market
  3. Acting upon unsolicited investment advice
  4. Using money kept aside to address contingencies, to invest in equities
  5. Disregarding asset allocation best suited for you
  6. Expecting supernormal returns
  7. Discontinuing SIPs in worthy mutual fund schemes (fearing that the markets are at a high)
  8. Not holding adequate cash in the bank

Although India is perceived as a ‘bright spot’ in the global economy, and valuations may seem reasonable on a 5-year average trail P/E basis (of around 26x), compared to the trail P/Es of the MSCI Emerging Markets Index and MSCI World Index trail P/Es (which are around 14x and 20x, respectively, as per their latest factsheets), Indian equities are still expensive. While this does not insinuate that Indian equities may descend or fall, it is time to be cautious as the margin of safety seems to have narrowed.

In the near term, elevated inflation, hawkish monetary policy stance, weak global demand, chances of economic slowdown later this year, heightened geopolitical tensions, increased volatility in the financial markets, geoeconomic fragmentation, and forthcoming in the United States and India in 2024 are the key risks for the capital markets.

Thus, follow a sensible path and be a thoughtful investor.

Happy Investing!

This article first appeared on PersonalFN here


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