If you are one of the 90 million individual investors in the U.S. who owns a mutual fund, you might want to take a good look at your strategy. If you’re a typical buy-and-hold mutual fund investor, your investing strategy may have a significant downside — and we’re not just talking about performance.

This downside to many mutual fund investing portfolios is called “overlap” or “drift,” and it works against you when your fund gets too big and too successful. While that may not sound like bad news, it can be expensive and risky as your fund drifts away from their stated investment objectives and overlap with holdings in other funds or ETFs.

So how can you prevent this problem?

Drift happens when mutual funds deviate from their names and prospectuses, and stray from their stated investing mandate over time. For instance, growth funds start to buy value stocks, or large cap funds start to hold cash or begin investing in NASDAQ companies. So when a portfolio manager starts to go their own way, it can take your well-planned diversification strategy into a new direction you never intended to go.

There are three ways overlap can happen:

#1 – Style Drift. If you invest in a growth stock with a capital-gains orientation, as well as an equity income fund with a goal of acheving capital-gains, both funds could easily own many of the same stocks.

#2 – Capitalization Changes. Over time, a company’s capitalization can increase from small-cap to mid-cap. This growth alters your desired small cap exposure.

#3 – Investment Product Overlap. By definition, ETFs are indexes comprised of different weightings in underlying stocks. When ETFs are combined with mutual funds, investors may find that despite the different products, they hold many of the same stocks.

While these changes occur slowly, they create problems. First, you have no control over the process. Plus, if you are paying a financial professional to make asset allocation decisions, their results will be hindered by undetected portfolio overlap.

So, with all this downside potential, how can you prevent your portfolio’s diversification plans from going astray?

Why Overlap Happens

Since investing is a social activity, fund managers often follow the same thought processes, share the same research and get caught in national moods which can focus their attention on a limited number of stocks. This is human.

Another complicating factor is that huge multi-national conglomerates often defy simple descriptions since they are involved in many different businesses and appeal to managers for a variety of reasons. That helps explain why a company like Microsoft (NASDAQ: MSFT) would be a top holding in a technology, Internet, large cap, wireless or a global mutual fund.

Small cap managers often face a simple problem as companies grow over time. By definition, some small cap managers should sell those stocks as they push past the fund’s stated capitalization limits, but many managers violate their own rules. Instead, they will rationalize their holding since it is something they have held for years.

The problem with owning too few stocks is that you are not diversified. This is a problem which cuts both ways: In the event of a market decline, you do not have enough stocks which may cushion your landing. On the upside, holding too few stocks cuts into your chance of making a broad-based gain.

Style drift can be a problem for investors who are concerned about having specific fund investment-style percentages within certain asset classes. For instance, if your target diversification for small-cap funds is 10% and your small-cap fund grows into the mid-cap category, your fund diversification will fall well below 10%.

So how should an investor check to see whether their diversification plans are actually being implemented in their holdings?

Checking for Overlap

The best way to check for overlap is to find the top 10 holdings in your mutual funds and compare them against each other. You can find those holdings in the mutual fund’s quarterly reports. However, that is a time-consuming process.

Then, there is the less detectable process of drift. For an individual, “this is next to impossible to detect,” according to Lawrence Balter, president of Oracle Investment Research. That’s because an individual may not often know what constitutes a small- versus a mid- or large-cap stock. Individuals also cannot differentiate between the price earnings and price-to-book ratios which are used to determine the valuation characteristics of a value or growth stock.

But for more intrepid investors, there are some Web alternatives which can easily make specific holdings comparisons on a quarterly basis. The first comes from the SEC’s own EDGAR database. While navigating this database may take practice, investors can view or download a specific fund by entering the fund name, trading symbol or special Central Index Key (CIK) number which is unique to the EDGAR system. With this CIK, you can isolate a specific fund and see its most recent filings, including its most recent individual holdings. These holdings (listed by sector, number of shares and most recent market value) are contained in SEC Form N-Q.

Morningstar.com also offers an overlap detection program in its Portfolio X-Ray feature available to its premium members.

Financial professionals or very serious investors can pay an annual fee to access the Overlap program (www.overlap.com). This software downloads the SEC’s EDGAR data base daily and creates client-friendly PDFs showing up to 40 funds in a single one-page comparison. Overlapping exposures are then segregated by individual equities, sector weightings and by country.