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Morningstar.com's Interactive Classroom

Course 110
Avoiding Overlap When Building a Portfolio

Introduction

Investments often come in different shapes and packages, but many have similar contents. For example, two seemingly different mutual funds can own the same stocks. In September 2012, for example, the top 10 holdings of Fidelity Magellan (FMAGX) and Fidelity Growth & Income (FGRIX) had five stocks in common.

There's nothing wrong with such portfolio overlap per se, and there’s no saying that two funds with heavy overlap at the top can’t ever be complementary. However, any time you see that much redundancy in two funds’ top 10 lists, it’s wise to ask yourself if you’re not using two investments to do the job that one could do just as well. And if both funds emphasize large positions in the same names, you may have built a portfolio that’s overly dependent on a few stocks. Overlap flies in the face of diversification. Here are some suggestions for how to avoid stock overlap in your portfolio. For more information about portfolio overlap, check out Funds 501: Avoiding Overlap When Building a Portfolio.

How to Avoid Overlap

If you're worried about duplication, remember these tips when building your portfolio.

1. Don't buy multiple funds run by the same manager. Zebras don't change their stripes, and managers often gravitate to the same stocks for multiple portfolios. That's because fund managers have ingrained investment habits that they apply to every pool of money they run. So if you buy two funds by Famous Manager A, chances are you'll own two of the same thing.

2. Don't overload on one boutique's funds. Some fund families, such as Fidelity, T. Rowe Price, and Vanguard, offer lineups of funds that span a variety of investment styles. Other shops, called boutiques, prefer to specialize in a particular style. Royce is a small-cap specialist, Oakmark means value, and Matthews equals Asia. Boutique families are often excellent at what they do, but it's questionable whether owning three of their funds gives you anything you won't get with one.

3. Take the four-corners approach. Using the Morningstar Style Box can be a diversifier's best friend. The style box will not only tell you whether your manager is snapping up large-value stocks, but it also can lead you to funds that bear little resemblance to one another.

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 attract. If you own a large-value fund from your favorite fund company, try one of its large-growth, small-value, or small-growth offerings.

Don’t assume that your portfolio’s weightings must be evenly dispersed across the style box, though. Although the U.S. market has a fairly even distribution across value, blend, and growth investing styles, large-cap stocks make up roughly 75% of the value of the U.S. market.

4. Manage your sector weightings. If two funds from the same category sport similar sector weightings, they may own many of the same stocks.

5. Determine how much overlap you might have. You've followed these tips and have put together a portfolio of investments or possible investments. To test for overlap, you could enter all of the investments--both the stocks you've bought directly and every stock that your mutual funds own--into a spreadsheet and sort by stock name. That's a lot of work. Morningstar.com offers a Portfolio X-Ray feature called Stock Intersection that can do this overlap analysis for you. (Note that Portfolio X-Ray is a feature available only to Morningstar.com Premium Members, but you can take advantage of a free 14-day trial.)

Using Morningstar.com's Portfolio X-Ray

Here's what you need to do to X-ray your portfolio for stock overlap on Morningstar.com. (Feel free to print out this class and hold on to these directions for future reference.)

1. Sign up for Morningstar.com's Premium Membership.

2. Click on Morningstar.com's Portfolio Manager.

3. Click on Create New Portfolio.

4. Name Your Portfolio.

5. Choose either a Watch List or a Transaction Portfolio. A Transaction Portfolio is far more precise than a Watch List Portfolio, and is the better choice overall, because it allows you to more effectively monitor your actual purchases over time.

6. For each of your funds and stocks, enter the ticker and the amount of money you have invested.

7. Click the Save Portfolio button at the bottom of the page.

Now it's time to X-ray. Click on the X-Ray tab and then click the Stock Intersection button. (The other buttons, X-Ray Details and X-Ray Interpreter, are different ways to examine how your portfolio fits together.)

The program examines each fund's top 50 holdings (a fund's 51st and succeeding holdings aren't likely to be significant stakes) and weights them according to how much you have invested in each fund.

So what did you find? Higher weightings in certain stocks than you wanted?

Remember, outsized positions—say, those that account for 5% or more of your total assets—can add return potential to your portfolio, but they can also contribute outsized volatility.

Quiz 110
There is only one correct answer to each question.

1 What's wrong with portfolio overlap?
a. It can lead to more company-specific risk than you bargained for.
b. It flies in the face of diversification.
c. Both A and B.
2 What is a "boutique"?
a. A fund family with a diverse lineup of funds
b. A fund family that specializes in one style of investing
c. A fund family that sells funds from other families
3 To avoid portfolio overlap?
a. Buy funds run by the same fund manager.
b. Buy multiple funds from the same boutique family.
c. Manage your sector weightings.
4 If you want to diversify a large-growth portfolio, add...
a. A large-value fund.
b. A large-blend fund.
c. A small-value fund.
5 To avoid overlap, go easy on the number of...
a. Large-cap funds that you own.
b. Mid-cap funds that you own.
c. Small-cap funds that you own.
To take the quiz and win credits toward Morningstar Rewards go to
the quiz page.
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