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Avoiding Portfolio Overlap

Answer these questions to check whether you're suffering from portfolio overlap

Morningstar 11 July, 2013 | 7:00AM

If you've been following our education theme then by now you will have determined your investment goals, figured out what you'll need to earn to reach them, and found investments that match those goals and your risk tolerance. Your portfolio is built, and you're ready to relax.

Not So Fast

Face it: Investing is a lifetime activity and you'll need to continue to monitor what you have created. Just as a parent never stops parenting, an investor never stops investing. So even after making all these decisions, you now face a more difficult—yes, more difficult—part of the process: monitoring your portfolio and learning how and when to make changes.

One of the very first problems you may face is the problem of portfolio overlap: You may have one or two individual stocks, investment styles, or sectors overrepresented in your portfolio. After investing for a while, investors often find that though their funds come in different wrappers, many have similar content. In other words, these investors have too much of one thing. To gauge how much overlap your portfolio has, you can do some hefty calculations by hand, using shareholder reports. Alternately, you can enter your portfolio in a tracking tool such as Morningstar.co.uk's Portfolio X-Ray.

To gauge your portfolio overlap, answer the following questions about your portfolio:

Do you favour one investment style over another?
The Morningstar Style Box can be an investor's best friend when it comes to making sure that your portfolio is still diversified. Based on a fund's most recent portfolio, the style box will not only tell you whether your manager has gone whole hog into large-value stocks, but it can also lead you to funds that bear little resemblance to one another. After all, value funds don't act much like growth portfolios, and small-cap funds behave differently from large-cap offerings. In style-box lingo, opposite corners should attract. If you're too heavy in large value, try increasing your position in large-growth, small-value, or small-growth offerings.

Do you have too much in any one stock?
Sometimes, two funds' portfolios may look slightly different, but you need to be aware of how much you own of any particular stock. For example, both fund managers may have made outsized commitments to mobile phone giant Vodafone, increasing your issue-specific risk.

If you invested in only one or two funds, you could determine your portfolio overlap by scouring shareholder reports and punching numbers into a calculator. But if you own more than a few funds or if you want to see just how another fund might change your current portfolio mix, this process is cumbersome. The Morningstar X-ray tool offers an easy way for Morningstar users to check for overlap.

The programme examines each fund's underlying holdings and weights them according to how much you have invested in each fund. If you have included individual stocks in your portfolio, the programme can easily consider them in the final balance as well. This is particularly important if you own a significant amount of your employer's stock; you may find that your funds also own that same stock. There's nothing wrong with holding some of your employer's stock, but you need to balance that investment with the rest of your portfolio.

Do you favour one or two sectors over others?
Even if you find that you don't have a lot of overlap in individual stock names, you may still be overexposed to one or two sectors of the market.

As an example let's take technology, a sector that has received a lot of attention in the new century. Technology has been a wonderful long-term return story (most of us remember that it seemed like the only story in the late 1990s), so fund managers have often spent a lot of money shopping in this industry. One of the reasons that the market's volatility has been so painful for some of us is that investors were generally more exposed to this sector than they had realised.

Growth funds, in particular, usually carried large tech weightings with lofty prices and even loftier earnings expectations. The average large-growth fund kept far more of its assets in technology stocks than in any other sector of the market. Mid- and small-growth funds held even more of their assets in tech names. Many investors with multiple growth funds owned a lot more technology stocks than they realised.

The technology example may be overused, but that's partly because it was especially egregious. Keep in mind that at any given time there is likely to be a sector that grows to prominence among growth or value funds. It's a good idea to X-Ray your portfolio regularly to make sure that it hasn't become too skewed one way or another.

Do you own too many large-cap funds?
Large-cap offerings make great core holdings, but it's easy to overdose on them. After all, they often get a lot of media coverage, they're easy to buy, and they're pretty simple to understand. It's vital that investors avoid large-cap addiction—especially large-cap offerings from the same fund family. Here's why: The large-cap universe is relatively small. Generally, a fund shop's managers will draw upon a single research pool, so there's a good chance of overlap if you buy multiple large-cap funds from a single family. In fact, there is little justification for owning more than one large-blend fund. So once you have picked up a large-value and a large-growth fund—or a single large-blend fund—start looking at options elsewhere in the style box.

Do you own multiple funds run by the same manager?
Zebras don't change their stripes, and fund managers rarely change their investment styles. If you own two funds managed by Famous Manager A, chances are you own two of the same thing. That's because managers generally have ingrained investment habits that they apply to every pool of money they run. So no matter how much you love a particular manager, don't buy more than one of his or her offerings if you are serious about diversification.

Do you own multiple funds from one boutique family?
Fund families that specialise in particular regions or sectors may well be excellent at what they do, but it's unlikely that owning three of their funds gives you much more than you'd get with one.

Nevertheless, many of the big firms provide opportunities to diversify, and a handful, such as Fidelity and Vanguard, can truly claim to be one-stop shops. Moreover, many savvy fund families now offer their own fund supermarkets, which allow investors to sample funds from other shops while still remaining loyal to their favourite families. That's a win-win situation.

The information contained within is for educational and informational purposes ONLY. It is not intended nor should it be considered an invitation or inducement to buy or sell a security or securities noted within nor should it be viewed as a communication intended to persuade or incite you to buy or sell security or securities noted within. Any commentary provided is the opinion of the author and should not be considered a personalised recommendation. The information contained within should not be a person's sole basis for making an investment decision. Please contact your financial professional before making an investment decision.

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