When I ran a software development company, the search term that landed us the most website traffic was "dedupe iTunes." People who had two copies of, for example, Justin Bieber's "Baby," didn't need the extra copy, and my partner had written a simple script to remove the extra copy, freeing up space for more Justin Bieber songs.
What many people don't realize is that they may also have a need to "dedupe" their mutual funds.
If you hold multiple funds, particularly those that are actively managed, you may hold funds which contain several of the same stocks in their underlying holdings. This is called mutual fund overlap. For example, you may hold four actively managed growth mutual funds, and all four of the fund managers got Roombas for Christmas. After seeing the Roomba zip around the house sucking up dirt, each manager decides to put in a big investment in iRobot (IRBT). You end up in a position where you're not diversified because, while the names of your funds may differ, the underlying investment is still the same.
Why is it important to eliminate mutual fund overlap?
Arguments against overlap are arguments for meaningful diversification, and avoiding putting yourself in a position where negative performance in a select few stocks kneecaps your entire portfolio. Other reasons appropriate diversification is important include:
--Downside protection. While, naturally, it's impossible to guarantee returns, diversification does help ensure that if one sector had poor performance, or one stock within a sector struggled, your entire investment kitty doesn't go down the drain.
--Upside exposure. Appropriate diversification allows you to make small bets on catching the next hot stock or hot sector without taking unnecessary risks. If a sector, say, healthcare, does well next year, you'll have some investment in it and get to benefit from the sector's strength.
--Controlled volatility. With the appropriate diversification, you can choose the beta--the amount that your portfolio generally goes up and down in time with the overall market--to manage the amount of risk you're willing to take (and potential need for antacid if you don't like huge swings).
How do you check for overlap?
I really wish there was a quick and easy way to do this. Morningstar offers a tool called Instant X-Ray which can give you a measurement of overlap which appears to be the best in the business; however, you have to pay for the service after a 14 day trial. Your brokerage may also offer a similar tool to compare holdings.
If you're looking for the free way to do it, this is what I suggest:
First, one caveat:. unless you're investing in index funds from a known index (e.g., the S&P 500 index), it's nearly impossible to say what a given fund is holding at any one time. The best you can do is look at the latest prospectus to get the most recent holdings. You can get a top 10 holding list from sources like Yahoo! Finance, but going that route will rarely give you sufficient information to determine true overlap.
So, first you will need to go to the prospectus or the shareholder report of each of the mutual funds you are evaluating. You're looking for the schedule of investments. You'll want to create a spreadsheet (note: if you do not own Microsoft Excel, you can use OpenOffice or Google Documents to accomplish the same thing, but I am going to write this for Excel users) and list each of the holdings and the amount of the holding. This is going to take a while. If you want to go for bonus points, you can find the historical prices as of the day of the filing for each of the stocks to determine how many shares the fund owned, and then calculate the current value of each stock holding.
Repeat this process for each mutual fund you're considering.
Now, you will want to take a pair of funds and copy them into a new worksheet. Put the underlying stocks in Columns A and C and the values in Columns B and D. In column E, you will want to create a series of cells which check for the uniqueness from one fund against the other. So, for example, in cell E1, use the formula:
Copy and paste this to all rows which have a value in Column C. Where there is overlap, you will get the names of the stocks. Where the stocks are unique, you will get blank spaces.
The next step is to calculate the percentage overlap. You will want to calculate how much of your money is invested in each of the overlapped stocks. To calculate this for each fund, you will, for each stock, take your investment amount and multiply it by the amount of the fund that the stock represents divided by the total amount.
So, for example, if Mutual Fund AAA holds $100,000 total, and it has $5,000 in IRBT - the only overlapped stock in this example, then IRBT represents 5 percent of the total holdings. If you have $5,000 invested in AAA, then you have $250 invested in IRBT - 5 percent * $5,000. If Mutual Fund BBB holds $1,000,000 total and has $20,000 in IRBT, then IRBT represents 2 percent of BBB's total holdings. If you have $10,000 invested in BBB, then you have $200 invested in IRBT through BBB, and $450 total in IRBT between your two mutual fund investments. There is a 1.33 percent overlap in your portfolio, as the $200 in IRBT in BBB (the lesser of the two amounts) is an overlap with AAA's IRBT holdings, divided by the $15,000 total you have invested in the two funds.
If this sounds brutal, it is. It may be worth considering investing in a service which calculates overlaps for you if you are going to pursue actively managed funds.
However, given that actively managed funds tend to underperform their benchmarks, an easier solution may be to invest solely in index funds and sector funds. One example would be if you wanted to get the total U.S. market, you could invest in USSPX, the USAA S&P 500 fund and USMIX, the USAA Extended Market Index fund, which invests in U.S. stocks in the Dow Jones U.S. Completion Total Stock Market Index aside from the S&P 500. Naturally, you'll want to consider fees and loads before engaging in any such strategy as well as ensuring that you achieve proper asset allocation.
If you're going to dedupe your mutual funds, be prepared to either pay for a service to analyze the overlap or to go through a few hours of manual slogging with a spreadsheet. Whichever way you choose, going through the exercise will be invaluable to ensure that you're achieving the portfolio diversity that you sought by buying mutual funds in the first place.
Jason Hull is a candidate for the CFP(R) Board's certification, is a Series 65 securities license holder, and owns Hull Financial Planning.