How to Avoid Portfolio Overlap

Redundancies can make your portfolio riskier.

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For many investors, diversification is a brute-force activity: By the sheer size of their portfolios, they look to insulate themselves from risk. In many cases, though, they’re inadvertently magnifying their potential for losses. That’s because without proper care, a seemingly diversified portfolio can become quite entangled.

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For instance, if two funds in a portfolio have Coca-Cola as their top holding, then the investor isn’t actually diversified. The problem compounds itself if there are several stocks in common. “If those particular equities that are held in those portfolios go down, you’re getting hit across all [fronts],” says Kevin Fryer, the president of Overlap, a firm that helps clients identify redundancies in their portfolios. As a result, reducing so-called portfolio overlap is one of the most important steps an investor can take to reduce risk.

But that’s easier said than done. Take, for instance, Fidelity Advisor Diversified Stock and Alger Large Cap Growth. At first glance, the two funds seem perfectly capable of coexisting within a single portfolio. The Alger fund, as its name implies, is a large growth fund, while the Fidelity fund falls into the large blend category. The top portion of Alger’s portfolio is overflowing with tech names like Google, Microsoft, and Apple, whereas Fidelity’s is anchored by picks like ExxonMobil and Chevron. In fact, just looking at each fund’s top five holdings, there’s not a single name in common.

A closer examination, though, shows that the funds have at least 20 stocks in common. According to Fryer’s software, a full 33 percent of their portfolios are identical to one another. The software measures overlap by taking the sum of lesser numbers. For example, if Fund A has 2 percent of its portfolio in Citigroup and 3 percent in Amazon, and Fund B has 4 percent of its holdings in Citigroup and 1 percent in Amazon, the total overlap would be 3 percent (2 percent for Citigroup and 1 percent for Amazon).

Dan Candura, the president of the financial planning firm PennyTree Advisers, says that portfolio overlap is a common problem. “It is something you see frequently because people have chosen to diversify across mutual funds, but they choose the same types of mutual funds,” he says. “So they end up with the underlying holdings being quite similar and the illusion of diversification.” He says that in most cases, it’s a question of an investor making “an accidental--and not a terribly strategic--allocation.”

Another common source of overlap is when investors load up on several funds from the same provider. For example, American Funds’ Fundamental Investors Fund and Growth Fund of America have 49 percent of their portfolios in common, according to Fryer.

The solution, most financial planners say, is for investors to pay more attention to asset classes. That’s because if blue chips struggle, an investor who owns 10 large growth funds likely won’t suffer noticeably less than an investor who owns just two. But when it comes to asset classes, diversification really can cushion the blow if a certain type of investment sustains losses.

If two funds in a portfolio overlap to a great degree, experts typically suggest selling one. When deciding which to eliminate, the standard questions still apply: Which fund has performed better? Which is more expensive? And are there tax benefits to holding one over the other?