Portfolio Overlapping

Portfolio Overlapping refers to a situation where multiple mutual funds in an investment portfolio contain similar or identical underlying assets. This occurs when investors or fund managers hold comparable securities or the same companies’ stocks across different portfolios, potentially leading to a lack of diversification.

Diversifying investments serves as a key to effectively managing or spreading risk. Hence, the primary concern arising from portfolio overlap is the non-diversification of fund allocation. When various mutual fund portfolios have securities belonging to the same companies or tracking similar stocks, they are highly susceptible to similar market fluctuations, exposing the overall investment portfolio to the risk of market failure.

• Portfolio overlapping occurs when multiple funds in an investor’s portfolio comprise securities belonging to similar companies or are tracking identical stocks. If an investor invests in different funds that follow similar investment strategies, they may end up holding a similar basket of stocks.
• Some common causes of portfolio overlap include fund managers selecting assets based on market trends or popularity, choosing prominent or well-known investment strategies, focusing only on top performers, following any previous arrangement/s, or giving in to personal biases and choices. Herd behavior is also a cause for such overlap.
• Portfolio overlapping results in non-diversification of investment, elevating the risk of exposure to market failure due to the inability to mitigate the impact of underperforming assets on the overall portfolio. Further, it raises transaction costs and lowers consolidated returns.

Portfolio overlapping occurs when multiple investments in a portfolio share similar characteristics or when money is put into the same asset class, indicating a high degree of correlation. Thus, these investments tend to move in one direction. While this might multiply an investor’s gains when the market is rising, it can lead to losses when the market falls, particularly if it is a sharp fall.

To understand this concept better, assume that mutual funds A and B, comprising five mid-cap securities each, have both invested in the stocks of P, Q, and R companies. Now, suppose an investor M’s portfolio includes both A and B mutual funds. In that case, there is a portfolio overlap where M has invested twice in P, Q, and R stocks, limiting the diversification of their portfolio.

Such overlap increases the portfolio’s vulnerability to specific market movements. In this situation, multiple investments respond similarly to market conditions, potentially leading to a lack of diversification. Hence, investors should spread their holdings to manage risk by including assets with low or negative correlations.

It is, therefore, essential to allocate investments across various asset classes, such as equity, real estate, bonds, and different industries and geographic regions. Investors should frequently review and adjust their portfolios to address such overlaps and build a strong investment profile that can withstand adverse market movements and conditions.

Overlapping portfolios are a common problem in mutual fund investments. They may result from the following factors:

• Market Trends and Popular Sectors: The companies and stocks trending in the market or contributing towards the sectors most in demand can result in overlapping. When particular sectors or industries display strong performance or attract investor attention for specific reasons, many mutual funds typically invest in such sectors without adequate review.
• Overlapping Strategies: At times, fund managers prepare identical portfolios centering on a favored asset allocation strategy or are driven by particular news or investor choices related to specific assets or securities. This leads to concentration in the form of similar holdings.
• Passive Investing Strategies: Investors employing passive strategies like index funds or exchange traded funds (ETFs) may unintentionally duplicate holdings from different funds, contributing to portfolio overlap. This happens because investors put their money in multiple funds that track the same indices.
• Behavioral Biases: Emotional decision-making, herd behavior, or overreliance on recent winners can make investors inadvertently neglect the importance of diversification, resulting in concentrated portfolios. Even a fund manager or asset management company’s individual choice of assets causes portfolio duplication.
• Neglecting Asset Correlations: Failure to consider the correlation between different assets in a portfolio can lead to unintentional overlap, especially if said diverse investments move in tandem during market fluctuations.
• Infrequent Portfolio Review: If a fund manager does not reassess the underlying holdings of an asset periodically, there are chances of repetition.

Overlapping portfolios, whether coincidentally or deliberately, can result in a repetition of risk and return profiles. While it is a profitable opportunity if the overlapping assets are the ones offering higher returns, it may lead to significant losses if such securities fall or underperform.

Example #1

Suppose Brenda invests in two funds equally, one that concentrates on insurance stocks and the other on technology.

If both portfolios include shares of XYZ Company specializing in insurtech with a weightage of 20% and 25%, respectively, there would be a portfolio overlap. Around 22.5% of the overall fund allocation is in XYZ Company.

Thus, Brenda’s exposure to XYZ Company is higher than intended, potentially impacting diversification benefits and increasing risk if the company encounters challenges.

Example #2

Let us compare the portfolio components of two prominent US stock index, ETFs, Nasdaq 100 (QQQ) and S&P 500 (SPY), as of 21 November 2023.

List of Nasdaq 100 (Q) components – Nasdaq 100 Companies by Weight

List of S&P 500 (SPY) components – S&P 500 Companies by Weight

Given below is a list of 10 overlapping stocks of QQQ and SPY:

In the above table, almost 30.83% of the S&P 500’s composition is similar to that of NASDAQ 100. Thus, if an investor holds both of the above ETFs or other similar securities, each tracking one of these indices, it becomes a clear case of a portfolio overlap.

Investors should thoroughly assess and manage portfolio overlapping to ensure a well-balanced and diversified investment strategy since such duplication of investments can result in the following adverse effects.

1. Overconcentration Risk: A substantial portion of a portfolio comprising similar assets increases the exposure to underperformance risk in those specific sectors or asset classes. Thus, if such an asset’s value falls, it can hinder the performance of the overall portfolio.
2. Limited Diversification: The fundamental purpose of diversification is to curtail risk by dispersing investments across distinct asset classes, sectors, and geographical areas. Portfolio overlapping undermines this principle, exposing the overall portfolio to specific market movements to a greater extent than usual.
3. Poor Return Potential: Holding the same securities may lead to a lack of exposure to new and potentially high-performing assets or sectors. If such an asset fails to provide the anticipated profits, the overall return potential of the portfolio is compromised.
4. High Transaction Costs: Managing multiple overlapping positions may result in higher transaction costs, as it requires more frequent trading to rebalance or adjust the portfolio. Moreover, the investor pays fund management charges to different fund managers for handling the same or similar assets.

It must be noted that a certain degree of overlap can potentially lead to more consistent returns, particularly if similar assets perform well across various investments.

Recognizing and addressing overlapping investments is crucial for risk diversification and optimizing an investor's overall portfolio strategy. Investors often face failures when they are unable to identify overlapping portfolios in their investments. They can use various mutual fund portfolio overlap tools like tables, graphs, and key performance metrics to draw a clear picture of duplicate assets in different investments.

Given below are some methods to examine portfolio overlapping instances:

1. Manual Comparison: Investors can compare the holdings of different portfolios by reviewing each one individually and noting common assets. It is equally important to check the weightage of the overlapping stocks for a more comprehensive analysis.
2. Portfolio Analysis Tools: Multiple portfolio analysis software are available online, such as the ETF Research Center, for an efficient comparison. Alternatively, one can utilize spreadsheet functions like VLOOKUP or MATCH to obtain and study comparative tables and graphs.

Portfolio overlapping across mutual fund investments is a common problem for new investors or those who need to still learn what a fund carries. The following are specific measures that help minimize such repetition across fund allocations.

1. Investors or portfolio managers should diversify their investments across various asset classes, industries, and geographic regions. They should avoid picking more than two funds from the same asset category.
2. Conducting regular reviews of the holdings and comparing and examining the correlations between investments is necessary for effective portfolio management.
3. Not falling prey to herd mentality or behavior and resisting the urge to depend on friends and family for fund selection is crucial; instead, investors should conduct proper research before making asset selections for their investment portfolio.
4. Investors must ensure to add assets that contribute based on the purpose they serve in achieving the overall portfolio strategy.
5. Periodically assessing and rebalancing the investment portfolio to maintain the desired asset allocation and minimize potential overlap is essential. Investors or portfolio managers should eliminate similar or identical schemes that have been underperforming consistently.
6. At the time of rebalancing, establishing clear criteria for selecting assets, considering factors such as growth potential, risk, and their correlation with existing holdings is important.
7. Investors should avoid picking multiple schemes from the same asset management company or fund manager to eliminate the chances of similar asset allocation strategies across different investments.

This article has been a guide to what is Portfolio Overlapping. Here, we explain how to check it, its causes, effects, examples, and how to reduce it. You may also find some useful articles here -

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