Staying Diversified – Detecting and Correcting Mutual Fund Overlap

Diversifying your investments can help to reduce volatility in your portfolio and potentially increase your returns over the long term.

But under some circumstances, holding multiple funds actually can reduce the effectiveness of your investment strategy: Two or more funds may emphasize the same or similar parts of the market
and result in a portfolio concentrated in a particular stock, industry, economic sector, or geographic region—and this can dilute your portfolio’s diversification. Fortunately, checking your portfolio for fund overlap is easy.
Mutual funds invest in up to hundreds of securities, making them ideal building blocks for constructing a diversified portfolio. Some funds—retirement-date funds or asset allocation funds—provide broad, professionally managed diversification in a single investment. But investors need to know what their different funds hold. “Fund overlap exposes you to the risk of having too much money invested in one part of the market,” says Stuart Ritter, CFP®, a financial planner with T. Rowe Price. “And, in some instances, this can result in below-average returns and above-average volatility, which, in turn, might prevent you from reaching your investment goals.” To maintain the diversification necessary to achieve your financial goals, Ritter advises checking your portfolio at least once a year for overlap and taking steps to correct it. Of course, diversification cannot assure a profit or protect against loss in down markets.

Origins of Mutual Fund Overlap

Consider an investor who holds two equity funds: a large-cap domestic stock fund and a technology fund. If the domestic stock fund owns 10 large, multinational technology stocks among its 100 holdings, the investor’s allocation to the sector might represent nearly a third of the portfolio. And if some of the stock holdings are the same in both funds, the investor’s exposure to individual stocks would add an additional layer of overexposure. As a result, returns and risk in this portfolio would be tied to the performance of this one sector—even certain stocks—more closely than is appropriate.
The concentration caused by redundancies in multiple funds represents a potential lost opportunity—assets in overlapping funds likely would be put to better use invested according to your fully diversified investment strategy. It is critical, therefore, to identify over-concentrations in your portfolio and take steps to eliminate them.

Hidden Concentrations

Overlap can occur in your portfolio in many ways—and may even be imperceptible without a close examination of your holdings. You might assume, for instance, that overlap would not be a concern with two funds that employ significantly different strategies, such as a value fund and a growth fund. But redundancies may crop up nonetheless. The growth manager might emphasize a particular consumer staples stock because of the company’s exposure to rapidly expanding markets, while a value manager might prize the company’s reliable cash flows.
Straying from your investment strategy also may cause overweightings in particular parts of the market. In this era of 24-hour, real-time market news, you may be tempted to chase trends by focusing on certain types of funds, such as those that invest in specific economic sectors or subsectors. But if you hold a diversified portfolio, you likely already have exposure to the types of stocks represented in those funds. Say, for example, you were to increase your exposure to gold by purchasing shares of an ETF (exchange-traded fund) that attempts to reflect the performance of the price of gold bullion. Your stock funds already may own shares of many gold-related stocks—so your new investment could take your allocation to gold stocks from moderate to excessive. Purchasing a sector fund concentrates your overall exposure to a niche of the market, boosting your risk and potentially hampering long-term returns.

Maintaining Diversification

You can start addressing fund overlap by thoroughly examining your portfolio. Begin with a review of your asset allocation. Consider whether the balance of stocks, bonds, and short-term investments remains appropriate for your goals and time horizons.
Next, evaluate diversification within each asset class with the help of Morningstar® Portfolio X-Ray®. (See the sidebar on page 19.) This tool can help you determine how buying or selling a fund will affect your holdings. For your equity allocation, T. Rowe Price recommends holding 55% in large-cap U.S. stocks, 15% in mid- and small-cap U.S. stocks, and 30% in international stocks (including developed and emerging markets). Also, review your portfolio’s exposure to growth and value—you should have similar allocations to each investment style. Check how much you hold in each economic sector as well. Your sector weights should be similar to those of the broad market. And review your stakes in individual companies to make sure no one stock represents more than 5% to 10% of your overall investment portfolio.

Avoiding Overlap

A few steps can help you avoid investing in funds with positions that overlap significantly. Taking time to investigate fund holdings closely before you invest can ensure that new investments won’t bring redundant exposures to your portfolio.
Target-date and asset allocation funds offer another solution for preventing fund overlap. These types of funds put asset allocation decisions in the hands of professional money managers, who can efficiently monitor how market trends and day-to-day changes affect the overall positions represented in the fund. “Owning just a single fund is okay if you invest in the right one,” Ritter explains. “To attain optimal, broad diversification, your portfolio needs hundreds of stocks and bonds of different types. Target-date and asset allocation funds can provide this portfolio solution in one fund.”

Repairing Overlap

It’s important to set aside time every year to review your portfolio. You can take this opportunity to look for redundancies among your investments. If you discover that your funds have significant overlapping holdings, take corrective action right away. Ritter cautions against the inclination to ease out of a redundant position over time or to rebalance your portfolio gradually in order to manage the tax consequences. “Tax considerations shouldn’t override a sound investment strategy,” Ritter says. “The goal is to bring your portfolio back to your target allocation by selling investments in the redundant and overweighted sub-asset classes and using new contributions to purchase shares of underrepresented areas. In this way, you can ensure that your portfolio is properly diversified and stays within a level of risk that is consistent with your goals.” Portfolio X-Ray can help you with each step. (See the sidebar at right.)
The end of the year can be a good time to review your portfolio, and now may be especially vital due to significant shifts in the financial markets. The events of the past year highlight the importance of maintaining thorough diversification. No investor could have foreseen exactly how developments such as the sovereign debt crisis in Europe would evolve. Regularly examining your portfolio to ensure you maintain exposure to a wide array of assets can help you weather short-term shifts and stay on top of mutual fund overlap as you pursue your long-term objectives.