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Course 501
Avoiding Portfolio Overlap

Introduction

Success! You 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 (such as behemoths General Electric GE or Microsoft MSFT), 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.com's Portfolio Manager.

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

Do You Favor 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 computer giant Microsoft, 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.com  Instant X-Ray tool offers an easy way for Morningstar.com Premium Members to check for overlap.

The program examines each fund's top holdings and weights them according to how much you have invested in each fund. If you have included individual stocks in your portfolio, the program 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 in your 401(k) plan; you may find that your mutual 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 Favor 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 mutual fund managers have often spent a lot of money shopping in this industry. One of the reasons that the market's volatility was so painful for some of us in the last four years is that investors were generally more exposed to this sector than they had realized.

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—37% in mid-2000—than in any other sector of the market. (In comparison, the S&P 500 Index had about 30% of its assets in tech stocks at the time.) Mid- and small-growth funds held even more of their assets, about 40%, in tech names. Many investors with multiple growth funds owned a lot more technology stocks than they realized. More recently, exposures to this sector have declined slightly as managers have hoped to find the next big thing in other industries.

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 gotten 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. Less than 9% of all stocks can be classified as "large cap." 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. Incidentally, the odds of duplication increase if you stick to large-blend funds, the universe of the S&P 500. 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. Owners of Mutual Shares MUTHX, formerly run by Michael Price, wouldn't have gained much from picking up sibling Mutual Beacon BEGRX.

Do You Own Multiple Funds from One Boutique Family?

The Matthews funds are specialists in Asia; Oakmark concentrates on value. Such fund families are 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 favorite families. That's a win-win situation.

Quiz 501
There is only one correct answer to each question.

1 Why is portfolio overlap a greater risk for fund investors who also own individual stocks?
a. Because individual stocks are riskier than funds.
b. Because the investor's funds may also own this stock, making the investor's overall portfolio more concentrated than it seems.
c. Portfolio overlap isn't a greater risk for fund investors who also own individual stocks.
2 If you own a lot of growth funds, chances are you're overweight in what sector of the market?
a. Technology.
b. Financials.
c. Utilities.
3 How many large-blend funds should you own if you already have a large-value and a large-growth fund?
a. Two.
b. One.
c. Maybe none.
4 If you own one fund run by Manager A, how many other funds of his or hers should you own if you value diversification?
a. None.
b. One.
c. As many as you want.
5 If you own one fund from a boutique fund family, how many other funds should you own from that same family if you value diversification?
a. None.
b. One.
c. As many as you want.
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