Overlap refers to the same stocks appearing across fund portfolios.
The Securities and Exchange Board of India plans to tighten scrutiny when a fund house launches a new sector or thematic scheme.
Sebi will seek a model portfolio and examine whether the proposed fund overlaps with an existing scheme from the same fund house by more than 50 per cent.
While this addresses overlaps at the fund-house level, investors must also scrutinise their own portfolios for overlaps.
Sebi Tightens Scrutiny
Overlap refers to the same stocks appearing across fund portfolios.
"Such overlapping funds move in tandem, reducing diversification benefit," says Kaustubh Belapurkar, director - manager research, Morningstar Investment Research India.
Mindless addition of funds
Overlap typically arises when investors add too many funds indiscriminately, often belonging to the same category, based on past returns.
Buying multiple schemes run by the same fund manager (say, a flexicap and an ELSS fund) also results in overlap.
Investing in more than one sector or thematic fund from the same sector or theme, which have a limited universe of stocks to choose from, increases overlap.
Many of the stocks held by sector and thematic funds are already present in diversified funds.
"New fund offers also contribute. As portfolios are not disclosed at launch, investors are unable to assess common holdings," says Vishal Dhawan, founder and CEO, Plan Ahead Wealth Advisors.
How to check for portfolio overlap
For a basic check, download the portfolios of the two funds in Excel and identify the common stocks -- at least the top 10.
"Examine not just the names but also the weightages. A stock having 10 per cent weight in one fund and 1 per cent in another would cause only a minor overlap," says Dhawan.
Several mutual fund web sites have online tools for checking portfolio overlaps, though some require a subscription.
To prevent overlap at the portfolio construction stage, diversify by market cap, style, and geography.
Diversification by market cap
Different market caps perform differently across cycles.
"Large caps offer stability when markets struggle. Mid and smallcap stocks generate higher long-term returns but experience sharper drawdowns," says Deepesh Raghaw, a Sebi-registered investment advisor.
Diversifying across large, mid and small cap funds can combine the benefits of participation in rallies with downside protection, Raghaw adds.
Investors with higher risk tolerance and longer investment horizons can have higher exposure to mid and smallcap funds.
Diversification by style
Investment styles -- growth, value, momentum and quality -- also go through cycles.
"No one can predict which style will outperform at which point in time," says Belapurkar.
Blending various styles in a portfolio can ensure that some part of it performs, irrespective of which style is in favour.
Investors can assess a fund's style through fund disclosures, style boxes, Sebi's categorisation, and fund managers' commentary on their investment approach.
Diversification by geography
Geographical diversification smoothens portfolio performance as different markets don't always move sync.
"Domestic and international markets respond to varied drivers such as commodity cycles, technology cycles, interest rates, inflation and geopolitics," says Dhawan.
Overseas exposure, Belapurkar adds, provides access to businesses not available on the local bourses.
Raghaw points out that international diversification offers a hedge against rupee depreciation.
How to remove overlap
Some overlap is inevitable.
"If it is excessive, investors may need to exit certain schemes, while minimising tax incidence and exit load," says Dhawan.
"Alternatively, directing fresh money into underrepresented areas can gradually reduce overlap," adds Dhawan.
To restructure your portfolio, begin by deciding on an asset allocation across equity, debt, precious metals and real estate based on risk tolerance and horizon.
Next, decide the exposure to sub-asset classes. Finally, Raghaw cautions that before adding a new fund to the portfolio, investors must ensure it will add value.
Key Points
- Portfolio overlap reduces diversification, as funds with common stocks tend to move together.
- Investors often create overlap by adding too many similar or same-category funds.
- Checking common stocks and their weightages is essential before adding a new fund.
- Diversifying by market cap, style and geography helps limit overlap and improve balance.
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Feature Presentation: Ashish Narsale/Rediff
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