Bloomberg's Lu Wang has a great story this morning detailing the challenges active managers face in an environment where a few mega-cap companies are driving the index to record highs.
The basic problem is simple math: Since the Magnificent Seven stocks make up about 30% of the S&P 500, and investors can't hold these stocks in that ratio, you can't keep up with the benchmark index by matching the benchmark. Now, of course, mutual fund managers could stuff their funds with ETFs that track the S&P 500. But that's not why investors pay the increased fees that active funds charge.
Specifically, it's about the Investment Company Act of 1940, which regulates how actively managed stock funds can behave.
As Robby Greengold of Morningstar wrote last year, the law implies that “an allocation of 5% or more to any single security is uncomfortably high; To achieve diversification status, a mutual fund must limit the total proportion of such positions to 25% of its capital assets.”
Specifically, Section 5 of the Act states:
“Diversified Company” means a management company that meets the following requirements: At least 75 percent of the value of its total assets is represented by cash and cash equivalents (including accounts receivable), government securities, securities of other investment companies and other securities. For the purposes of this calculation, the value is in relation limited to a single issuer to an amount not exceeding 5 percent of the value of the total assets of that management company and not more than 10 percent of the outstanding voting securities of that issuer.
Essentially, your fund must be largely liquid, investments must be widely diversified and remain largely passive in terms of managing the companies in which it is invested. And this last point represents another noteworthy aspect for the active fund management community.
Most investors who use mutual funds to allocate capital probably do not aspire to become activist investors. However, if this were the case, these rules rule out this possible strategic wrinkle. Just another reason the investment world is a treacherous place for stock pickers.