Diversification can be a dummy exercise. So, check this for best result.

Diversifying your investment is great. Portfolio overlap? Not so much. It can be a side-effect in your pursuit to diversify (spread your investments). So, if you are investing across multiple funds, ensure they are not investing in similar stocks.

Take large-cap funds, for example. Investing in more than one active large-cap fund can be futile. Here's why: these funds invest at least 80 per cent of their money in the 100 largest companies by market value. Given the small investment pool of 100 companies, there is a strong likelihood of large-cap funds investing in the same stocks.

The large-cap offerings from Aditya Birla Sun Life (ABSL) and Canara Robeco are Exhibit A. Their portfolio is 71 per cent similar to each other. Unsurprisingly, their performances kind of dovetail with each other (ABSL's 20 per cent and Canara Robeco's 21.8 per cent) and saw negative returns in 18 out of 20 market downturns over the past 60 months.

If you thought this is an outlier, the average overlap among large-cap funds is no better. Their portfolios are around 46 per cent alike. The performance is in a similar ballpark as well, with just 2.1 per cent deviation over a five-year period. In short, investing in more than one large-cap fund makes little sense.

Mid- and small-cap funds

These funds are relatively immune from the copycat syndrome. Why? Mid-cap funds primarily have 150 companies to choose from, while small-cap schemes have a universe of 4,000-plus companies. This diversity leads to lower overlap - just 26 per cent among mid-cap funds and 13 per cent among small caps. As a result, their performances have greater divergence.

Ditto with flexi-cap and multi-cap funds. Since these two have the flexibility to invest across the entire spectrum of large, mid and small caps, their portfolio overlap numbers are at a lower end, in the 22-24 per cent range.

Funds of the same AMC

If you're considering multiple funds from the same fund house (AMCs), check before doing so. Many fund houses may have a monolithic investment philosophy and often install the same fund manager, leading to significant overlaps. UTI ELSS Tax Saver and UTI Children's Equity Fund are a case in point, with a staggering 98 per cent portfolio resemblance.

Interestingly, flexi-cap and ELSS (tax-saving) funds of the same AMC can also be prone to aping each other. Despite having different use cases, they have pretty similar investment mandates. As such, Franklin Templeton's ELSS and flexi-cap offerings have a 94 per cent likeness. It's not a one-off example either. There are five other fund houses where the portfolios of their ELSS and flexi-cap schemes are at least 70 per cent similar.

Sectoral funds

The discussion on portfolio overlap wouldn't be complete without mentioning sectoral funds. Since these funds focus on specific industries, like Technology or Healthcare, it naturally limits the number of companies they can invest in. Among sectoral/thematic funds, Banking funds show the highest overlap, with a 72 per cent resemblance between HDFC Banking & Financial Services and Kotak Banking & Financial Services.

A quick checklist

• Avoid investing in multiple large-cap funds; they often mirror each other.
  
• Mid- and small-cap funds don't usually suffer from the problem of portfolio overlap.
  
• Be cautious when investing in multiple funds of the same fund house.
  
• ELSS (tax-saving) and flexi-cap funds from the same AMC can also have significant overlap.
  
• Diversification is key but choose your funds wisely to ensure true diversification.
  
• Periodically review your portfolio for overlaps and adjust as necessary.

Also read: The limits of diversification