What Is Fund Overlap?
Fund Overlap occurs when an investor owns two or more mutual funds that have similar objectives and therefore hold many of the same securities. For a simple example, if an investor owns two stock mutual funds and they both invest in many of the same stocks, the similarities create an effect of reducing the benefits of diversification by increasing exposure to those same stocks—an unwanted increase in market risk.
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.
How to Detect and Avoid Fund Overlap
The most simple way to detect and avoid fund overlap is to look at the fund categories to be sure your mutual funds do not share similar objectives. For example, try not to have more than one large-cap stock or index fund, one foreign stock fund, one small-cap stock fund, one bond fund, and so on.
If you prefer to have several funds, or you have a 401(k) plan with limited choices, you can detect fund overlap by looking on one of the best research sites for analyzing mutual funds and look 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. Therefore, if you already have an S&P 500 Index fund, be sure that other funds in your portfolio do not have an R-squared that is too close to 100. This would indicate a level of fund overlap that causes both funds to perform similarly. Remember, for proper diversification--to minimize market risk—you want some funds to "zig" while others "zag."
Example of Overlap Using R-squared on Morningstar
Many people have 401(k) plans or IRAs at Vanguard. A common investment choice is Vanguard S&P 500 Index (VFINX). What if another choice in the plan was Vanguard Growth Equity (VGEQX)? Would you know if there was overlap? Let's find out. You can go to Morningstar.com and enter a search for VGEQX. Once on that fund's main page, look for a link to "Ratings and Risk" and click on it. Once on that page, scroll down and you'll see that the R-squared is 97.
This number indicates that VGEQX has a 97% correlation in price movements to the S&P 500. In other words, it has too much fund overlap to provide proper diversification. Look for a different fund choice (don't use both the S&P 500 Fund and VGEQX)!
Another way to detect the potential that fund overlap exists is to be sure you don't have more than one fund managed by the same fund manager. No matter how brilliant the person or team may be, mutual fund managers have particular philosophies and styles that they rarely deviate from.
On a final note, be sure to monitor fund overlap on a periodic basis, such as one year. Even if the funds in your portfolio had low levels of overlap when you first purchased them, it doesn't mean their respective styles won't 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.
Disclaimer: The information on this site is provided for discussion purposes only, and should not be misconstrued as investment advice. Under no circumstances does this information represent a recommendation to buy or sell securities.