Investing in numerous mutual fund schemes may not lead to adequate diversification if these funds hold substantial investments in the same stocks. Here are strategies to improve diversification.

The golden rule of investing, 'Don’t put all your eggs in one basket,' is essential when building a portfolio. Diversification across different avenues offers a safety net, minimizing risk if one investment falters. For instance, if you only invest in equities, a market crash could diminish your entire portfolio. Allocating assets in debt and gold can cushion against such shocks.

Another diversification tactic involves investing across various stocks or funds to reduce the impact of underperformance on your portfolio. However, merely investing in multiple funds doesn’t guarantee diversification. If these funds have a significant overlap, it limits their diversification effectiveness. Hence, avoiding portfolio overlap becomes crucial. Here's how:

Understanding Portfolio Overlap in Mutual Funds

Mutual funds invest in stocks and bonds for clients, but equity funds often allocate funds to the same companies, leading to an overlap. For example, Bandhan Large Cap and Union Large Cap Funds have a 67% and 62% allocation in overlapping stocks respectively. If you invest Rs. 100 in each, Rs. 129 ends up in the same stocks, demonstrating a lack of diversification.

Overlap in Major Funds:

• Bandhan Large Cap vs. Union Large Cap: 67% vs. 62%
• Bandhan Flexi Cap vs. Canara Robeco Flexicap: 68% vs. 56%
• PGIM India Flexi Cap vs. Canara Robeco Flexicap: 66% vs. 55%
• Aditya Birla Focused Equity vs. LIC MF Focused 30 Equity: 54% vs. 52%

This overlap leads to similar returns for these funds. Thus, if these stocks underperform, your portfolio might suffer significantly.

Why Portfolio Overlap Occurs

1. Regulatory Mandates by SEBI

Until 2018, there were no clear mandates on fund investments in categories. SEBI redefined investment categories to ensure consistency. For instance, large-cap funds now must invest 80% in the top 100 stocks, leading to overlaps in these limited investment universes, especially compared to mid-cap and small-cap categories, which have broader universes.

2. AMC-Specific Investment Approach

Portfolio overlaps may result from investments concentrated within the same Asset Management Companies (AMCs) due to their distinct strategies. An AMC's philosophy guides its fund managers, often causing similarities in stock selections across different categories.

Examples of Portfolio Overlap among Prominent Funds

Axis Funds: In August 2020, Axis funds showed significant overlaps due to their growth and quality investing style, impacting performance across various market conditions.

Similarly, SBI Mutual Fund and ICICI Prudential had noticeable overlaps among their portfolios by August 2023, reflecting a broader trend across major fund houses.

Minimizing Portfolio Overlap

While it's impossible to eliminate overlap, strategies can be used to reduce it. Ideally, try to keep overlaps under 33% for optimal diversification.

1. Diversify Across Fund Categories: Select funds from categories with notably different investment universes.
2. Select Funds from Different AMCs: Broaden your investment scope by engaging with funds managed by different AMCs to exploit their varied philosophies.
3. Regularly Review Portfolio: Continuously examine overlapping stocks within your portfolio as part of ongoing reviews.

Technological tools, like the Portfolio Health Tool on ET Money, can aid in regularly assessing and managing overlaps, ensuring no redundancy in your investment strategy.

Conclusion

While mutual fund portfolios inherently carry a risk of overlap, investors can take active measures to minimize it through strategic diversification across fund categories and AMCs. Regular portfolio reviews ensure sustained diversification benefits. Utilize tools like ET Money's Mutual Fund Health Check-up to evaluate your portfolio across various critical parameters, enhancing your decision-making process.