NEW YORK (MainStreet) -- Redundancy is standard operating procedure for NASA space missions -- but for investing, not so much. Duplicate holdings don't serve much purpose in an investment portfolio, but, unfortunately, most of these drags on performance are hidden. It's called "overlap," and it's a hazard found in mutual fund and ETF holdings.
"The S&P 500 was Vanguard's flagship, the first index fund launched in 1976, and a lot of people use that fund," says Walter Lenhard, a senior investment analyst for the Vanguard Equity Investment Group. "But the most popular fund these days is our Total Stock Market portfolio. And there's a lot of overlap. If you buy both of those funds, you really have about a 75% overlap in large- and mid-cap names."
There are lots of companies - even whole sectors - that can be duplicated inside a mutual fund or ETF. That's not exactly in the spirit of diversifying. Investors buy index funds, thinking they have a broad market covered - but not realizing that two funds with totally different names can be duplicating an investment strategy. You may want exposure to emerging market stocks, but are you sure you want to double down?
Ask your investment advisor to produce a mutual fund holdings list on your portfolio. You may be surprised how many of your funds are holding Apple (AAPL - Get Report) , Bank of America (BAC - Get Report) and Amazon (AMZN - Get Report) . That's not necessarily a bad thing; it's just a hint as to how much overlap may be occurring in your portfolio. In fact, two-thirds of the companies represented in the CRSP mid-cap index are in the S&P 500 large-cap index.
But the problem goes beyond investments classified by company size - large-cap, mid-cap, small-cap and so on - it can also be complicated by matters of style (such as growth and value) and sector (like technology and financials). In other words, a small-cap fund may be fishing in the same pond as your technology fund. That large-cap mutual fund is buying the same stocks as your S&P500 index ETF.
And with overlap comes a gap.
"If you're not careful, you might create a portfolio completely missing an entire country, or doubling the weight of that country," Lenhard said. "If you use the S&P 500 for your large-cap exposure and then you went with another very popular index, the Russell 2000, you're really missing a lot of the mid-cap names between the two."
Think of it this way: If all of your players are covering right field, what happens when Latin American stocks knock a home run into left field?
Overlap issues can begin at the very formative stages of a portfolio's construction. Research fielded by UCLA and the University of Chicago in 2001 revealed that many investors have a tendency to choose nearly every investment offered in their 401(k), all in an effort to "diversify."
In another study conducted last year by the University of Pennsylvania, investors were presented a menu of ten mutual funds to choose from. One-third chose to divide their investment among all ten funds, even though two were clearly identified as S&P 500 index funds with identical past performance records.
"Ten or fifteen years ago, people were more interested in the Morningstar nine style boxes, or slicing and dicing the market," Lenhard says. "They wanted small-cap value, mid-cap growth -- these days the trend is in the exact opposite direction. They want an aggregate solution, one solution that's going to cover as much [of the market] as possible."
Simplifying your portfolio with total market funds and ETFs may be the first step in reducing overlap and closing the gap that drags down your portfolio's performance.