The Restrictions Hitting US Funds

A rebalancing act is needed, not just for Nasdaq, but for many US "diversified" funds.

Many of the largest US investment funds are being blocked from buying more shares in popular stocks due to diversification rules as they struggle to keep up with indices that a few massive tech groups increasingly dominate.

Famous asset managers and experts in mutual funds, such as Fidelity, BlackRock, JPMorgan Asset Management, American Century, and Morgan Stanley Investment Management, have encountered stringent regulatory restrictions when deciding whether a fund qualifies as “diversified.”

The trend follows the news that even the Nasdaq 100, the index most closely associated with high-flying tech groups, will be rebalanced to lessen the dominance of the largest groups, such as Apple, Microsoft, and Nvidia. It indicates how a lopsided rally powered by just a few big companies creates unexpected issues for investors and index providers.

The S&P 500 has increased by 18% this year, yet most gains have come from seven significant tech stocks.

Diversification requirements

Mutual funds that register with the Securities and Exchange Commission as “diversified” cannot put more than 25 per cent of their assets into large holdings — with a large holding defined as a stock representing more than 5 per cent of the fund’s portfolio at the time of investment. Funds are not punished if the value of their existing large holdings naturally rises past the 25 per cent limit, but once it is hit, they cannot buy any more of the affected stocks.

At the end of May, Fidelity’s $108bn Contrafund, for example, could not buy any more shares in Meta, Berkshire Hathaway, Microsoft and Amazon because they made up a combined 32 per cent of its portfolio. BlackRock’s Technology Opportunities Fund was blocked from buying more shares in Apple, Microsoft and Nvidia, while JPMorgan’s large-cap growth fund was over the limit for Microsoft, Apple, Nvidia, Alphabet and Amazon.

The recent rally means that even funds that merely mirror major benchmarks, such as the Russell 1000 Growth Index, would exceed this limit.

The SEC said in 2019 that it would not enforce the more stringent 25 per cent limit on passive investment funds that breach the guidelines while tracking an index, but the restrictions make it harder for active managers to make bets.

An opportunity to recategorise

Some asset managers, such as T Rowe Price, have recategorised many of their funds as “non-diversified”. This allows them to make more concentrated bets but requires shareholder approval and may put off potential clients who assume a non-diversified fund is hazardous.

Stephen Cohen, a partner at law firm Dechert, said the most likely outcome for any fund that inadvertently broke the rules would be for the SEC to force them back into compliance. However, funds that lost money while in breach could also be exposed to legal action from investors.

Nasdaq’s changes, announced earlier this month and coming into effect on Monday, underline how index providers face similar pressures to diversify their holdings. The Nasdaq 100 will be updated next week because it passed a separate, looser regulatory threshold that required the combined weight of large holdings to be less than 50 per cent.

The combined weighting of the six largest companies on the Nasdaq 100 will be reduced from 50 per cent to 40 per cent, so any funds that track the index can continue to meet the requirements to be a regulated investment company.

So where will the money go?

Tech stocks will have to cool off. This does not mean that they will sell, but the pace at which they are being bought up could slow. Funds are ever-increasing their exposure to equities this year, so money will still be flowing into the markets. But where to?

Our bets are on the Dow Jones, the “boring” stocks your grandfather probably owns.

Price has broken out of a key resistance this week. We announced on our Twitter that we were buying Dow Jones 35,500 calls for August 18th. In just a few days, we are up over 100% on this position, but we are expecting a further move.

By the end of Q3, we expect the Dow Jones index to be testing all-time highs above 36,500.

Also, individual names in the Dow could be good to keep an eye on. We released a list that we were watching on our Twitter (you should really go and follow us there), which included names such as:

Boeing
Chevron
Home Depot
Honeywell
Johnson & Johnson
Salesforce