INVESTOR PLUS

An Annual Review of Your FinancesSTAYING DIVERSIFIED

Detecting and Correcting
Portfolio Overlap.

An Annual Review of Your Financesiversifying your investments can help to reduce volatility in your portfolio and potentially increase your returns over the long term. But under some circumstances, holding multiple funds actually can reduce the effectiveness of your investment strategy: Two or more funds may emphasize the same or similar parts of the market and result in a portfolio concentrated in a particular stock, industry, economic sector, or geographic region—and this can dilute your portfolio's diversification. Fortunately, checking your portfolio for fund overlap is easy.

Mutual funds invest in up to hundreds of securities, making them ideal building blocks for constructing a diversified portfolio. Some funds—retirement-date funds or asset allocation funds—provide broad, professionally managed diversification in a single investment. But investors need to know what their different funds hold. "Fund overlap exposes you to the risk of having too much money invested in one part of the market," says Stuart Ritter, CFP®, a senior financial planner with T. Rowe Price. "And, in some instances, this can result in below-average returns and above-average volatility, which, in turn, might prevent you from reaching your investment goals." To maintain the diversification necessary to achieve your financial goals, Ritter advises checking your portfolio at least once a year for overlap and taking steps to correct it. Of course, diversification cannot assure a profit or protect against loss in down markets.

Origins of Mutual Fund Overlap

Consider an investor who holds two equity funds: a large-cap domestic stock fund and a technology fund. If the domestic stock fund owns 10 large, multinational technology stocks among its 100 holdings, the investor's allocation to the sector might represent nearly a third of the portfolio. And if some of the stock holdings are the same in both funds, the investor's exposure to individual stocks would add a layer of overexposure. As a result, returns and risk in this portfolio would be tied to the performance of this one sector—even certain stocks—more closely than is appropriate.

The concentration caused by redundancies in multiple funds represents a potential lost opportunity—assets in overlapping funds likely would be put to better use invested according to your fully diversified investment strategy. It is critical, therefore, to identify over-concentrations in your portfolio and take steps to eliminate them.

Click to see Red Flags for Overlap. Click to see Red Flags for Overlap
Hidden Concentrations

Overlap can occur in your portfolio in many ways—and may even be imperceptible without a close examination of your holdings. You might assume, for instance, that overlap would not be a concern with two funds that employ significantly different strategies, such as a value fund and a growth fund. But redundancies may crop up nonetheless. The growth manager might emphasize a particular consumer staples stock because of the company's exposure to rapidly expanding markets, while a value manager might prize the company's reliable cash flows.

Straying from your investment strategy also may cause overweightings in particular parts of the market. In this era of 24-hour, real-time market news, you may be tempted to chase trends by focusing on certain types of funds, such as those that invest in specific economic sectors or subsectors. But if you hold a diversified portfolio, you likely already have exposure to the types of stocks represented in those funds. Say, for example, you were to increase your exposure to gold by purchasing shares of an ETF (exchange-traded fund) that attempts to reflect the performance of the price of gold bullion. Your stock funds already may own shares of many gold-related stocks—so your new investment could take your allocation to gold stocks from moderate to excessive. Purchasing a sector fund concentrates your overall exposure to a niche of the market, boosting your risk and potentially hampering long-term returns.

Click to see The Company Stock Factor. Click to see The Company Stock Factor
Maintaining Diversification

You can start addressing fund overlap by thoroughly examining your portfolio. Begin with a review of your asset allocation. Consider whether the balance of stocks, bonds, and short-term investments remains appropriate for your goals and time horizons.

Next, evaluate diversification within each asset class with the help of Morningstar® Portfolio X-Ray®. This tool can help you determine how buying or selling a fund will affect your holdings. For your equity allocation, T. Rowe Price recommends holding 55% in large-cap U.S. stocks, 15% in mid- and small-cap U.S. stocks, and 30% in international stocks (including developed and emerging markets). Also, review your portfolio's exposure to growth and value—you should have similar allocations to each investment style. Check how much you hold in each economic sector as well. Your sector weights should be similar to those of the broad market. And review your stakes in individual companies to make sure no one stock represents more than 5% to 10% of your overall investment portfolio.

Avoiding Overlap

A few steps can help you avoid investing in funds with positions that overlap significantly. Taking time to investigate fund holdings closely before you invest can ensure that new investments won' bring redundant exposures to your portfolio. Target-date and asset allocation funds offer another solution for preventing fund overlap. These types of funds put asset allocation decisions in the hands of professional money managers, who can efficiently monitor how market trends and day-to-day changes affect the overall positions represented in the fund. "Owning just a single fund is okay if you invest in the right one," Ritter explains. "To attain optimal, broad diversification, your portfolio needs hundreds of stocks and bonds of different types. Target-date and asset allocation funds can provide this portfolio solution in one fund."

Repairing Overlap

It's important to set aside time every year to review your portfolio. You can take this opportunity to look for redundancies among your investments. If you discover that your funds have significant overlapping holdings, take corrective action right away. Ritter cautions against the inclination to ease out of a redundant position over time or to rebalance your portfolio gradually in order to manage the tax consequences. "Tax considerations shouldn't override a sound investment strategy," Ritter says. "The goal is to bring your portfolio back to your target allocation by selling investments in the redundant and overweighted sub-asset classes and using new contributions to purchase shares of underrepresented areas. In this way, you can ensure that your portfolio is properly diversified and stays within a level of risk that is consistent with your goals." Portfolio X-Ray can help you with each step. Financial markets shift continually—and those changes can cause portfolio imbalances. The events of the past several years highlight the importance of maintaining thorough diversification. Regularly examining your portfolio to ensure you maintain exposure to a wide array of assets can help you weather short-term shifts and stay on top of mutual fund overlap as you pursue your long-term objectives. 

Morningstar® Portfolio X-Ray®

This tool, available on the T. Rowe Price website, is a complementary application that can provide you with an in-depth look at the holdings in your portfolio. To access Portfolio X-Ray, just log in to your account or register as a guest. This tool is especially useful in helping to detect overlap, although you should be aware that the data are not in real time.

The X-Ray tool provides information on your exposure to different sectors, stock types, sub-asset classes, and foreign assets. Valuable features include:

ASSET ALLOCATION

Shows how much of your portfolio is allocated to U.S. stocks, foreign stocks, bonds, cash, and other asset classes.

BOND STYLE BOX

Displays the interest rate sensitivity and credit quality of your fixed income holdings.

STOCK SECTOR

Exhibits the percentage you hold in each of a list of economic sectors and the corresponding weights of the S&P 500.

STOCK TYPE

Shows the precentages you hold in various kinds of stocks, including high yield, distressed, cyclical, and classic growth.

STYLE BOX

Illustrates your allocations to value, growth, and core stocks of companies of various sizes.

WORLD REGION

Maps your exposure to different regions of the world.

ILLUSTRATION FROM GETTY IMAGES

1 Moving all or some of the assets in your Traditional IRA to a Roth IRA may provide you with greater financial flexibility.
2 Stuart Ritter, CFP®, a senior financial planner with T. Rowe Price, explains how short-term investments can help stabilize your portfolio.
3 Dan Shackelford, portfolio manager of the T. Rowe Price New Income Fund (PRCIX), focuses on maintaining stability and maximizing current income.
4 The T. Rowe Price Spectrum International Fund (PSILX) invests in up to 13 T. Rowe Price international funds
5 A systematic approach to investing can help you reach your goals.
6 The sector includes a variety of commercial investments—and has performed well against inflation and the stock market.
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12 Options for Your Former Workplace Retirement Plan Asset.
12 Detecting and correcting portfolio overlap can help reduce volatility in your portfolio and potentially increase returns.