Fund Overlap: What it Means in Investment Strategy

What Is Fund Overlap?

Fund overlap is a situation where an investor owns shares in several mutual funds or exchange traded funds (ETFs) with overlapping positions. For instance, if an investor owns both an S&P 500 index mutual fund and a technology sector ETF, they would be overlapping quite a bit with the FAANG stocks (i.e., Meta (formerly Facebook), Apple, Amazon, Netflix, and Google), because those stocks are large components of both funds' portfolios. This could create too much concentration in just a few companies' shares.

Fund overlap reduces the benefits of diversification for the investor and may create unseen risks.

Understanding Fund Overlap

While small amounts of overlap are to be expected, extreme cases of fund overlap can expose an investor to unexpectedly high levels of company or sector risk, which can distort portfolio returns when compared with a relevant benchmark.

It can be very difficult for a retail investor to keep track of individual fund holdings, but a quarterly or annual check can help investors understand the strategy of each individual fund and provide an opportunity to compare top holdings from one fund with another.

If, for example, two separate mutual funds both have overweighted the same stock, it might be worth replacing one of the funds with a similar fund that does not carry that stock as a top holding. If a specific sector is overweighted in two funds (such as an overweight position in technology relative to the S&P 500), the investor will need to weigh the benefits and risks of this increased exposure.

Overweighting Sectors

Overweight is a situation where an investment portfolio holds an excess amount of a particular security when compared to the security's weight in the underlying benchmark portfolio.

Actively managed portfolios will make a security overweight when doing so allows the portfolio to achieve excess returns. Overweight can also refer to an investment analyst's opinion that the security will outperform its industry, its sector, or the entire market.

Securities will usually be overweight when a portfolio manager believes that the security will outperform other securities in the portfolio. An example of having a security being overweight in an investment portfolio would be when a portfolio normally holds a security at a weight of 15%, but the security's weight is raised to 25% in an attempt to increase the return of the portfolio. Another reason for overweighting a security in a portfolio is to hedge or reduce the risk from another overweight position.

The alternative weighting recommendations are equal weight or underweight. Equal weight implies that the security is expected to perform in line with the index, while underweight implies that the security is expected to lag the index in question.

Fund Overlap and Diversification

Fund managers and investors often diversify their investments across asset classes and determine what percentages of the portfolio to allocate to each. These can include stocks and bonds, real estate, ETFs, commodities, short-term investments, and alternative asset classes. They will then diversify among investments within the asset classes, such as by selecting stocks from various sectors that tend to have low return correlation, or by choosing stocks with different market capitalizations.

In the case of bonds, investors select from investment-grade corporate bonds, U.S. Treasuries, state and municipal bonds, high-yield bonds, and other fixed income securities.