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Understanding and Managing Overlap in Investment Portfolios: A Guide to Smart Diversification
When it comes to managing an investment portfolio, one of the most essential principles is diversification. Diversification helps reduce risk by spreading investments across various assets, sectors, and regions, thereby preventing any single poor-performing asset from significantly affecting the entire portfolio. However, achieving true diversification is not always as straightforward as it seems, especially when your portfolio contains a combination of individual stocks and funds such as mutual funds, exchange-traded funds (ETFs), and investment trusts.
The Challenge of Managing Funds and Individual Stocks
For investors who hold only individual stocks, diversification can be easily assessed. The investor knows precisely what percentage of their portfolio is allocated to each stock. However, when it comes to owning stocks through various funds, this becomes much more complicated. Funds typically hold a wide array of stocks, which can sometimes include hundreds or even thousands of different companies. In such cases, investors may not always pay close attention to the specific stocks held within each fund. As long as the fund appears to be diversified by category, region, or sector, it is easy to assume that the portfolio is balanced.
This assumption, while often true on a broad level, can overlook a critical issue: the potential for overlapping holdings. The risk with overlapping holdings is that an investor may inadvertently accumulate a disproportionately large stake in a single stock or sector without realizing it, even though they have invested in multiple, seemingly diverse funds.
What Is Stock Overlap?
Stock overlap occurs when the same stock is held across multiple funds in an investor’s portfolio. This can happen when different funds—especially those that target specific sectors, regions, or strategies—invest in the same well-established, large-cap stocks. While each fund may seem to provide exposure to different markets or sectors, the underlying holdings may be strikingly similar. This can lead to significant overlap, where multiple funds are concentrated in the same companies.
The problem with stock overlap is that it defeats the purpose of diversification. Instead of holding a broad array of companies, an investor may find that a large portion of their portfolio is invested in a small group of stocks. This concentration risk can expose the portfolio to greater volatility, particularly if the performance of the overlapping stocks diverges from the rest of the market.
Example of Stock Overlap in Practice
Consider the following hypothetical portfolio consisting of three different funds:
- Henderson Global Financials (20% of the portfolio): This fund offers exposure to global financial stocks.
- Schroder UK Alpha Plus (30% of the portfolio): This is an actively managed UK equity fund that focuses on high-potential companies.
- Vanguard FTSE 100 ETF (50% of the portfolio): A core holding that tracks the FTSE 100 index, representing the 100 largest companies in the UK.
At first glance, this portfolio appears quite diversified. The Henderson Global Financials fund provides international diversification, and exposure to the global financial sector, while the Schroder UK Alpha Plus fund focuses on active management in the UK market. Finally, the Vanguard FTSE 100 ETF gives broad UK market exposure, tracking the performance of the FTSE 100 index.
However, upon closer examination, it becomes clear that there is substantial overlap in the underlying holdings of these three funds. Specifically, several of the major banks in the UK, such as Barclays (BARC), Lloyds Banking Group (LLOY), and HSBC (HSBA), appear across all three funds. These three banks together account for approximately 10% of the portfolio’s total value.
This overlap may seem like a risk, especially if these stocks experience a downturn or underperform relative to other sectors. While these banks are indeed large, well-established companies, holding such a significant portion of your portfolio in just three stocks—especially when those stocks are the same across multiple funds—can lead to unnecessary risk.
Why Overlap Is a Concern
Having stock overlap in a portfolio can have several negative consequences. Here are a few reasons why overlap should be carefully considered:
1. Reduced Diversification
The primary advantage of diversification is that it helps smooth out the volatility of an investor’s portfolio. By holding a wide variety of investments—whether in stocks, sectors, or geographic regions—an investor can reduce the impact of any single investment’s poor performance. However, if your portfolio has substantial overlap, you are not achieving the true diversification you may have intended. Instead of being spread across many different companies, sectors, and regions, you may have concentrated exposure to a few large stocks or sectors.
2. Increased Risk Exposure
Overlapping holdings can increase your exposure to specific risks. For example, if multiple funds in your portfolio hold the same bank stocks (as in the example above), your portfolio becomes highly dependent on the performance of the financial sector. This can make your portfolio more vulnerable to sector-specific risks, such as regulatory changes, economic downturns, or market shocks that disproportionately affect that sector.
3. Lack of True Diversification Across Asset Classes
Even if you hold multiple funds that invest in different sectors or regions, stock overlap can lead to a lack of true diversification across asset classes. For example, if you own multiple equity funds that hold the same stocks, your portfolio may have limited exposure to bonds, commodities, or other asset classes. This can leave your portfolio more exposed to market volatility and less balanced in terms of risk management.
4. Underperforming Portfolio
Overlapping holdings might reduce the overall performance of the portfolio, especially if the overlapping stocks are highly correlated. If multiple funds are investing in the same companies, the performance of those companies will heavily influence the overall performance of the portfolio. This means that the portfolio may be less able to benefit from the full spectrum of market opportunities and may fail to outperform a more diversified portfolio.
Identifying Stock Overlap in Your Portfolio
Identifying stock overlap can be time-consuming, especially for investors who hold a large number of funds. Reviewing the annual reports of each fund individually can be a cumbersome process, but fortunately, there are tools available that make this task easier. One such tool is Morningstar’s Portfolio X-Ray, which is available to Premium members.
Using Portfolio X-Ray to Spot Overlap
Morningstar’s Portfolio X-Ray tool allows you to analyze the underlying assets in your portfolio, making it easy to identify areas of overlap and assess whether your portfolio is properly diversified. Here’s how the process works:
- Access the Portfolio Manager: Start by entering your portfolio into Morningstar’s Portfolio Manager. You can enter individual stocks or funds that you hold, and the tool will aggregate them into one comprehensive portfolio.
- Select the Holding Overlap Feature: Within Portfolio X-Ray, there is an option called Holding Overlap. This allows you to see which stocks appear in multiple funds within your portfolio. The tool will display the percentage of each stock’s value in the overall portfolio, as well as which funds are holding that stock.
- Analyze the Results: The tool will present a clear breakdown of your portfolio’s holdings. You can see which stocks are present across multiple funds and how much of your portfolio is invested in each of them. This will help you assess whether certain stocks are overrepresented and whether you need to adjust your allocations.
- Adjust Your Portfolio: If the tool reveals significant overlap, you can take steps to adjust your portfolio. You may choose to reduce exposure to specific stocks by selling shares of funds that have concentrated holdings. Alternatively, you might consider reallocating your investments into funds that offer better diversification.
Practical Steps for Reducing Overlap
Once you identify stock overlap in your portfolio, you can take several steps to reduce your exposure to concentrated positions. Here are some strategies to consider:
1. Review Your Fund Holdings
Carefully review the top holdings of each fund in your portfolio. Even if the funds focus on different sectors or regions, it’s important to check for large positions in the same stocks. You can find this information in the fund’s fact sheet or annual report.
2. Reduce Exposure to Overlapping Stocks
If you discover that several funds are invested in the same stocks, you can reduce your exposure by selling some of your holdings in funds that are concentrated in those stocks. This may involve selling shares of specific funds or reallocating the capital into other funds that have different holdings.
3. Increase Exposure to Different Sectors and Regions
To achieve true diversification, consider increasing exposure to different sectors, regions, or asset classes. If your portfolio is heavily concentrated in financial stocks, for example, you could allocate more funds to other sectors such as technology, healthcare, or consumer staples. Additionally, if your portfolio is overly concentrated in a particular region (such as the UK), consider adding international exposure through global or emerging market funds.
4. Use Index Funds or ETFs for Broader Exposure
Index funds and ETFs typically offer more diversified exposure to a broad range of stocks, reducing the risk of overlap. By investing in a broad-market index fund, you can ensure that your portfolio holds a large number of different stocks, reducing the impact of any one company on your overall returns.
5. Monitor Your Portfolio Regularly
Diversification is not a one-time task. Over time, as markets change and funds evolve, the composition of your portfolio may shift. Regularly reviewing your portfolio and checking for overlap can help you stay on track and ensure that you are maintaining a diversified and well-balanced portfolio.
Conclusion
Managing stock overlap is a critical component of maintaining a well-diversified investment portfolio. While funds can provide convenient access to broad market exposure, they can also introduce unintended concentration risk. By using tools like Morningstar’s Portfolio X-Ray, investors can identify overlaps in their portfolio and take steps to reduce excessive exposure to specific stocks or sectors.
Ultimately, diversification remains one of the best ways to manage risk and ensure the long-term growth of your investments. By carefully monitoring your portfolio for overlap and making adjustments when necessary, you can maintain a diversified portfolio that aligns with your financial goals and risk tolerance. Regularly reviewing your holdings, using portfolio analysis tools, and making informed decisions will allow you to protect your investments and stay on track to meet your objectives.