Fund overlap occurs when an investor owns different mutual funds that hold many of the same securities or react similarly to market conditions. This limits the diversity of an investment portfolio. Minimizing fund overlap also lowers market risk for investors.
Learn how to detect and avoid fund overlap with your investments.
What Is Fund Overlap?
Fund overlap occurs when an investor owns two or more mutual funds that have similar objectives and hold many of the same securities. Fund overlap lowers the diversity of your portfolio and increases the risk level of your investments.
If, for example, 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 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 amount of overlap possible.
Fund overlap often happens because two funds may be attempting to do the same thing. For example, two index funds will hold many of the same stocks and both will attempt to mirror the S&P 500. They will have a high degree of fund overlap.
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.
Change in managers can also cause changes in fund overlap as a new manager or management team purchases stocks that are similar to a fund you already own.
If you own multiple mutual funds, you should regularly monitor them to check for fund overlap.
How to Get Rid of Fund Overlap
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.
Before you replace an old fund with a new one, check for overlap in the new fund as well.
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. This 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, diversify your portfolio of funds with one large-cap fund, one foreign stock fund, one small-cap stock fund, one bond fund, and so on.
Compare R-Squared Value of Funds
If you prefer to have several funds, or you have a 401(k) plan with limited choices, you can detect fund overlap by looking at a statistical measure called R-squared (R2).
R-squared will tell you a particular investment's correlation with (similarity to) a given benchmark. An R-squared of 100 indicates that all movements of a fund can be explained by movements in the index. An S&P 500 Index fund, for example, will have an R-squared of 100 with the S&P 500 benchmark.
You can go to Morningstar.com and search for individual funds. When you click on the "Ratings and Risk" heading, it will take you to a separate page that includes that fund's R-squared value.
R-squared values fall into three categories:
- 1–40%: low correlation to the benchmark
- 40%–70%: average correlation to the benchmark
- 70%–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 fall into the same category of R-squared values, that indicates 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 that fund overlap exists 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.
This means that funds with the same manager will likely behave in the same way or contain similar securities that the manager prefers. Diversifying your fund managers will help to diversify your holdings and avoid fund overlap.
- Fund overlap occurs when an investor owns different mutual funds that hold many of the same securities or react similarly to market conditions.
- Minimizing fund overlap also lowers market risk for investors.
- If you own multiple mutual funds, you should regularly monitor them to check for fund overlap and ensure that your investments are diversified.
- You can avoid fund overlap by buying funds with diverse objectives, investing in funds with different R-squared values, and avoiding funds managed by the same person or team.