Box overlap: definition, how to manage

• Fund overlap occurs when an investor owns several mutual funds or ETFs that share the same holdings.
• This can result in your portfolio being less diversified, which can magnify the risk of losses in a bear market.
• To prevent excessive interference with funds, it is important to review your portfolio regularly.

Diversification is one of the most important principles of investing. By allocating your assets in a wide variety of securities within and across different asset classes, you reduce your exposure to risk and

volatility

.

One way that investors achieve diversification is by owning a variety of mutual funds and exchange-traded funds (ETFs). However, if you choose this path, it is important to ensure that the overlap of funds does not undermine your efforts to create a diversified portfolio.

What is an overlap box?

Fund overlap occurs when an investor owns multiple mutual funds, ETFs, and sometimes individual stocks, with positions overlapping.

An example is owning the popular Invesco QQQ ETF, which tracks the Nasdaq 100 Index, and the Vanguard Total Stock Market.

index box

(VTI). Both hold important positions in many of the same companies. For example, as of mid-2022, they all had Apple, Microsoft, Amazon, Alphabet, Tesla, and Meta in the top 10 collectibles.

“One of the biggest risks of extreme overlap is the potential for heavily focused positions,” says Joshua Luetkmueller, chartered financial analyst (CFA) and head of investment strategy at Strongside Asset Management. “An investor may inadvertently create a portfolio that is highly concentrated by weight for only a few names, even though they may have the illusion of diversification because they own several funds.”

What causes box interference?

Each fund you invest in has an investment strategy and objectives described in its prospectus. Fund managers choose the securities that they decide will achieve their goals. The goal of a classic stock index fund is to track the performance of the entire stock market.

Fund overlap occurs when an investor selects funds that have different stated goals but use many of the same stocks to achieve them.

For example, a company like Tesla could appear in an environment-focused owned fund, or a fund geared toward technology stocks, as well as an index fund. In such a case, there will be a significant drop in Tesla shares in all three funds. The risk magnifies as the number of shares crossed into the funds you own increases.

Overlapping can also leave you overly exposed to certain sectors. “Every sector has periods of underperformance or underperformance, but you want to make sure you have the appropriate sector weights according to your asset allocation,” Lutkemuller says.

Example of box interference

Below is an example of a fund overlap using the current top-of-the-line SPDR S&P 500 ETF (SPY) and Vanguard Growth ETF (VUG), two of the most popular ETFs.

Each has a different goal. SPY tracks the performance of the 500 largest US companies. VUG’s goal is to track US growth stocks that are poised to outperform the broader stock market. Here are their top 10 holdings as of June 2022:

The graph shows significant overlap which exposes the investor to an increased level of risk. Keep in mind that these are only the largest of the collectibles and there may be more overlap if you dig deeper.

3 ways to reduce the overlap of funds

While completely eliminating the overlap of funds in your wallet may not be possible, it is important to keep it in check. Here are three ways to do this:

1. Understand the fund manager

Take the time to understand who is managing the fund and try to avoid having multiple funds run by the same manager. Fund managers implement the investment strategy and decide what to buy and sell.

“Managers have investing habits that are difficult to change, and they are more likely to sneak into other funds they manage,” Lutkemuller says.

2. Use the clipboard overlap tool

Consider using a tool to help visualize where there may be an overlap between the funds in your portfolio and how important it is. Morningstar money descriptions include charts that help illustrate how holdings are allocated and can be used to identify areas of your portfolio that may be overlapping. There are other options you can find with a quick search that can get the job done, including this one from the ETF Research Center.

Keep in mind that with these two tools you can get basic information about how much overlap two chests have, but you may need to create an account or pay for more advanced information.

3. Review your investments regularly

Monitoring the level of interference is not a one-time thing. You should review it at least once a year. Regular reviews are important because over time the securities in the funds you own may change due to changes in the business environment. Money that does not overlap now may be sometime in the future.