For example, if you own two mutual funds that invest in many of the same stocks, both investments will lose money under the same conditions. You reduce the benefits of diversification by increasing exposure to those same stocks, even though you own two different funds that initially appear to create a diverse portfolio.
How Mutual Fund Overlap Works
Imagine a Venn diagram with two circles, each representing a mutual fund, overlapping in the center. As an investor, you don’t want too much of an intersection between the circles—you want the least overlap possible. Fund overlap often happens because two funds may be attempting to do the same thing. For example, many index funds from different brokers that track the same index hold many of the same stocks. As a result, you’d have a high degree of fund overlap if you invested in two index funds from two different brokers that tracked the same index. However, fund overlap can also occur in two funds that have different goals and may initially have low levels of overlap. Over time, however, their respective styles may drift toward each other. This is called “style drift,” and it is not uncommon. For example, a mid-cap stock fund could slowly drift toward a large-cap categorization as the fund manager progressively buys stocks of larger companies. A change in managers can also cause changes in fund overlap as a new manager or management team purchases stocks that are similar to those held by a fund you already own.
What It Means for Individual Investors
Eliminating fund overlap is an important part of maintaining a diversified portfolio of investments. Once you have identified funds that have a high degree of overlap, choose one to keep in your portfolio, and replace the other with a new fund. There are several ways you can check for fund overlap.
Examine Fund Objectives
The simplest way to detect and avoid fund overlap is to look at the fund categories. That can help you select mutual funds that do not share similar objectives. For example, try not to have more than one large-cap stock or index fund. If you have two or more funds within the same category, they will hold many of the same securities and react to the market in similar ways. Instead, you could diversify your portfolio of funds with one large-cap fund, one foreign stock fund, one small-cap stock fund, and one bond fund.
Compare R-Squared Value of Funds
If you prefer to have several funds, or if you have a 401(k) plan with limited choices, you can detect fund overlap by looking at a statistical measure called “R-squared (R2),” or the “coefficient of determination.” R-squared will tell you a particular investment’s correlation with (similarity to) a given benchmark. An R-squared of 100 indicates that movements in the index can explain all movements of a fund. For example, an S&P 500 Index fund should have an R-squared of 100 with the S&P 500 benchmark. R-squared values fall into three categories:
1%–40%: low correlation to the benchmark40%–70%: average correlation to the benchmark70%–100%: high correlation to the benchmark
Look at the R-squared of funds in your portfolio, compared to the same benchmark. If any of your funds falls into the same category of R-squared values, there is a high degree of fund overlap. You may need to consider diversifying your funds to limit your market risk.
Look for Different Managers
Another way to detect the potential for fund overlap is to look at who manages the fund. No matter how brilliant the person or team may be, mutual fund managers have particular philosophies and styles that they rarely deviate from. Funds with the same manager will likely behave similarly or contain similar securities that the manager prefers. Diversifying your fund managers will help you diversify your holdings and avoid fund overlap.
