“Set it and forget” or “buy it and forget it” has been touted across the internet as an approach to passive investing. There’s some truth to it, but overall this may send the wrong message to investors. Here’s why:
You could be overexposed.
No, I’m not talking about a wardrobe malfunction. But possibly a portfolio malfunction.
Mutual funds and exchange-traded funds are investment vehicles that group similar types of stocks and bonds. The similarity depends on the fund manager or company creating the fund. For example, a mutual fund or ETF could track an index, invest in companies with similar market capitalization, or only buy companies with a sustainable mission. You name it, there is probably a fund that focuses on it.
That is not necessarily a bad thing. However, there is a possible downside: Mutual funds and ETFs allow investors to have little understanding of what securities they really hold.
Funds provide accessibility to the stock market for everyone. Mutual funds are one of the easiest ways to invest when making regular contributions, like you do in a 401(k) plan, because the shares are almost always available to purchase. They’recreated on-demand every day, and there are many more mutual funds to purchase than actively traded stocks.
It’s great that they provide accessibility to investing. The flip side is this: you have no idea what you’ve invested in, for the very reason that makes them so popular: Mutual funds can have hundreds of holdings.
These funds have limits about the percentage of overall dollars that can be invested in one stock. But if you own multiple mutual funds, which you probably do, then a portfolio checkup should be regularly scheduled maintenance. You may have fund overlap and hold too much of one asset class without knowing it.
Why is fund overlap a problem?
Let’s start with the basics. A healthy portfolio should be designed to achieve your financial goals with a certain risk-return tradeoff.
The relationship between risk and return means the amount of risk in your portfolio is approximate to the potential return. Low levels of risk assume lower potential returns, and high levels of risk come with higher potential returns, but also have a higher possibility of loss.
High-risk portfolios invest more in stocks than conservative portfolios that incorporate fixed income, like bonds or treasuries. When a larger percentage of your portfolio is allocated to stock, fluctuations in the market cause it to fall out of balance quicker, leaving you with more of your money invested in stocks than you intended.
Your goal is to diversify the risk of having your portfolio become dependent on the success of one particular asset class or sector. Imagine a stock has experienced sizable growth. The gain means more of your overall portfolio is allocated to that stock, and more likely to be affected if it takes a tumble.
How do you figure out if you have fund overlap?
It’s easier than you think. There are a few ways to approach it, and free tools can help you understand if your portfolio is unbalanced. Morningstar and Personal Capital offer portfolio analysis once you’ve registered with their site.
1. For those who prefer the ‘eyeball method’ to get a general idea, look at the top 10 holdings of each fund you own. You find them right from the fund’s website or through Morningstar. If those overlap, you need to think about a strategy to diversify.
Another way to compare fund holdings is by using Morningstar’s Portfolio Manager. Through the X-Ray feature, you can add the mutual funds you hold and see where stocks overlap. You’ll be surprised at what you learn, so it’s an exercise that might be worth your time.
For example, let’s look at these two funds.
- The Fidelity 500 Index Fund (FUSEX) tracks the S&P 500 index, one of the most well-known benchmarks. The fund falls into Morningstar’s large-blend category.
- The Vanguard Morgan Growth Fund (VMRGX) is benchmarked to the Russell 3000 Growth Index. The fund falls into Morningstar’s large-growth category.
A snapshot of the Portfolio X-Ray from Morningstar shows they own 17 of the same stocks, with the eight of the top stocks owned by both.
2. You can also evaluate fund overlap by looking at the R-squared using Morningstar’s fund quote. R-squared is a calculation that shows the correlation of a fund to its benchmark. For example, if a fund tracks the S&P 500 then it should have an R-squared value close to 100, representing an absolute tracking of the fund’s movements to the S&P.
Morningstar shows the R-squared of a fund by looking at the Ratings & Risk tab. Using the same examples as above, the R-squared value of FUSEX is 100 compared to the S&P 500. The R-squared value of VMRGX is 97.94 to the Russell 3000, and 88.31 to the S&P 500.
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Again, 100 is the maximum and indicates a very positive correlation to the index. You can see there’s overlap by looking at these measures.
R-squared can’t tell you everything, however. If you’ve identified potential overlap in your holdings, it’s best to consult a fee-only fiduciary who can make appropriate recommendations.
Selling a fund and purchasing a new one can create tax implications in a non-retirement account. A fiduciary can help you decide when it’s best to make changes, and how to make them most effective for your unique situation.
