Is it just me, or you no longer can do this with a free morningstar account, I think its only for premium pay accounts now?
Identify and Eliminate Overlap for Real Diversification
So, you’ve got a nice portfolio with a handful of index funds that include a good mix of growth, value, and various market caps. You’re diversified quite well, right? Not so fast. If you’re like most investors, even though you have a number of funds that you’re invested in, chances are there’s a lot of overlap going on.
What is fund overlap? To put it simply it just means that two different funds or ETFs share some of the same underlying holdings. The more overlap the funds have, the less diversified your overall portfolio. For example, if you own three large-cap stock funds and 85% of the holdings are found in each fund, what’s the point of owning three funds just to diversify 15% of your total portfolio? Ideally, you want to create an efficient portfolio where each fund or investment does a specific job and overlaps as little as possible with your other holdings. Otherwise you might find yourself holding a bunch of funds while only providing very little true diversification.
How to Find Overlap
How do you actually find out if your funds overlap? Thankfully, there is a easy and free tool provided by Morningstar called Instant X-Ray. To use it, all you’ll have to do is create a free account. Even better, is there are a bunch of additional tools you’ll then be able to use, but that’s a topic for another day. So, once you get logged in you’ll first be presented with a screen that looks like this:
You can see how simple it is. You just have to enter the ticker symbols and either the percentage or dollar amount of each holding. For this example I created a simple Vanguard large-cap stock portfolio:
- 50% Vanguard 500 Index (VFINX)
- 25% Vanguard Value Index (VIVAX)
- 25% Vanguard Growth Equity (VGEQX)
This is something many people would do with their portfolio, although the percentages would differ since you’d also have some other asset classes mixed in. But many people take the approach of putting the bulk of their investment into an S&P 500 index fund and then complement that with a few funds that focus specifically on growth and/or value. On the surface it seems like this would be a pretty broad portfolio encompassing virtually the entire large-cap equity universe, but is that really the case?
Getting the Results of the X-Ray
Once you enter your holdings and proceed to the next page you’ll be taken to the overall x-ray overview page, which looks like this:
As you can see, there is a lot of good information here. It analyzes your portfolio and gives you a detailed breakdown as to how the investments are spread out. While this is all useful, we can go one step further to specifically target fund overlap.
But before we do that I wanted to take a moment to highlight something. You’ll see I have highlighted some of the data in yellow on this image. The two columns represent your portfolio and the S&P 500. Without even moving on to the stock intersection tool we can see that even though you have three different funds, your portfolio is virtually identical to the S&P 500. Most categories vary by only a fraction of a percent! Think about that for a second. What’s the point of having three different funds just so it can look identical to what a single index fund looks like?
Detailed Stock Intersection Report
Going one step further, click on the “Intersection” tab at the top of the X-Ray report. This will take you to a detailed breakdown of the individual stock holdings inside each fund. For this example you’ll get this:
This image is just showing the top few holdings, but the list will go on and on detailing everything. But this one is sorted by the top holdings by percentage of your current portfolio. To understand what we’re seeing, let’s look at the top holding overall, which is ExxonMobil. Looking to the right you’ll see that it makes up 3.35% of your overall portfolio. Under that heading you’ll see that Exxon is held in two of your funds–the 500 index and the value fund. The numbers on the left represent what percentage of the fund is invested in Exxon. But what is of more interest is the numbers on the right which tell you the percentage in each fund as it stands in your portfolio.
Glancing at the list of the top 14 or so holdings you can quickly see that each stock is in at least two, and in many cases, all three of your funds. This seems like quite a bit of overlap, but what does the rest of the list look like? Well, you have to move down to the 29th largest holding to finally find a stock that is only in one of the three funds and doesn’t overlap at all. And guess what? That stock makes up just 0.81% of your portfolio. As you go down the list it takes another 10 holdings or so before you find another non-overlapping stock and they slowly begin to become more common as you reach the bottom of the list. But in most cases the stocks that don’t overlap make up just 0.10% to 0.65% of your total portfolio each. As a whole, less than 15% of your portfolio is made up of stocks that don’t overlap with your other holdings. That probably isn’t the kind of diversification you had in mind.
Fund overlap is just a fact of life when it comes to investing. There are only so many viable stocks out there to invest in and there will always be certain funds of different types that invest in some of the same stocks. Unless you’re crafting a custom portfolio of individual stocks by hand, don’t expect to eliminate all of the overlap. But having excessive overlap isn’t helping you create a diversified portfolio and it’s just complicating things with additional fund holdings that you may not need.
As you can see from the example we used above, even having three different large-cap funds with different investment styles, the end result was that nearly 90% of the stocks within the funds were found in the other funds and your overall portfolio looked nearly identical to the S&P 500. That was a slightly exaggerated example to make a point, but chances are you will have a few funds that overlap quite a bit and really aren’t helping you diversify.
So, keep things simple. Stick to just holding one or maybe two funds of each major asset class at the most. The most common and accessible classes are:
- Large-cap Domestic Stocks
- Mid-cap Domestic Stocks
- Small-cap Domestic Stocks
- International Stocks
- Aggressive Bonds
- Conservative Bonds
- Real Estate
Now, each of these asset classes are then broken down into things like value, growth, individual sectors, and international stocks may have specific regions and market caps, and there are all sorts of types of bonds. But as you saw from the example above, investing in various types of funds within the same broad category really didn’t do much good. To keep things simple, consider just an S&P 500 index fund to cover your large-cap, pick a small/mid-cap index to cover that category, and so on.
Sure, you may want to find some additional funds within a specific category to further diversify, but start with the basis and create your core portfolio with just one fund out of the major categories that gives you the proper overall allocation in line with your investment objectives and risk tolerance. Once you’ve created your core holdings you can then explore some specialty funds that can further diversify your portfolio. And the best part is you now have a tool at your disposal that can help you determine whether or not those funds make sense in meeting your diversification goals.
Remember, it isn’t the end of the world if you have a lot of overlap in your portfolio, but it can give you a false sense of diversification and expose you to more risk than you anticipated. It’s also just easier to manage a streamlined portfolio. You can own just 5 index funds and be more diversified than a portfolio with 20 funds. Guess which one will be easier to keep track of and monitor?
Go ahead and sign up for a free account at Morningstar and plug your holdings into the X-Ray tool to see where you stand. You might be surprised.
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About the Author: Jeremy Vohwinkle is a Chartered Retirement Planning Counselor® and spent a few years working as a financial planner. Today, he helps people make the most of their money by writing about personal finance here and elsewhere on the web. Jeremy is also Coach at Adaptu and a regular contributor for other publications such as Intuit, and American Express. Be sure to follow Jeremy on Twitter or Google+.
Great tool. I personally believe diversification has lost much of its strength as an investment tool. The CAPM model was built in a whole other era where covariance was much wider. With globalization the contribution of diversification is significantly reduced. Still, it is important to still enjoy other risk/reward tradeoffs without too much exposure.
Great article on overlap and the use of Morningstar's Instant E-Ray. I've used it for years, but never new about the Intersection Tab at the top of the report. Thanks.
I have seen this often with some of the mutual funds I have. You really have to be careful to check out the top stock investments that the mutual funds invest in to make sure that this does not happen. I had a large-cap international fund that I thought was investing in overseas companies, but was pretty close to another s&p 500 index, just with higher fees.