I’ve seen a number of the-sky-is-falling articles about issues mutual funds, and index funds in particular, are having in meeting SEC-mandated diversification of holdings. The relevant section of the Investment Company Act of 1940 is:

[a]t least 75 per centum of the value of its total assets is represented by cash and
cash items (including receivables), Government securities, securities of other
investment companies, and other securities for purposes of this calculation limited in
respect of any one issuer to an amount not greater in value than 5 per centum of the
value of the total assets[4] of such management company and to not more than 10 per
centum of the outstanding voting securities of such issuer.

If you’re a fund that doesn’t meet these requirements–and, given the recent meteoric rise of Nvidia to become all by itself 7%+ of the value of the S&P 500, no S&P 500 index fund/ETF does–you can continue with business as usual, but you have to make a public declaration that you are no longer “diversified,” in the technical sense specified in the 1940 Act.

As a practical matter, the rules to call yourself “diversified” are:

–for 25% of the portfolio, there are no position size restrictions

–for the remaining 75%, the rules are all about purchases of a given security, not sales

–you cannot make a new purchase of a given security, if the purchase either raises the weighting of an already-existing position above 5% of the assets or establishes a new holding at a weight of 5%+

Three geeky points:

–if you establish a 3% position that doubles while everything else in the portfolio treads water, so it’s now 6% of the assets, you don’t have to sell. The rule only applies to new purchases that bring the weighting up. Same thing if everything else craters and this becomes, say, 10% of the portfolio (in my view, you’d be crazy not to rebalance, but this rule doesn’t force you to–and in the real world, unless you own the management company, you probably won’t be around any more to make portfolio decisions)

–if you want to buy more of this stock, that’s ok, provided you mentally place it in the 25% of the portfolio that the rule doesn’t apply to

–if you want to run a more concentrated portfolio than these rules permit, you simply announce that you no longer intend to run a diversified portfolio in the sense of the Investment Company Act of 1940.

As for S&P index funds, the main issue is the meteoric rise of Nvidia to become the largest weighting in the S&P, at 7%.

As of just after the open on Feb 3, the top weights in the S&P 500 are:

Nvidia 6.95%

Apple 6.26%

Microsoft 4.86%

Amazon 4.04%

Alphabet 6.57% (two classes of GOOG)

That’s 28.7%.

So at least one of these has got to fall outside the 25% box where it’s ok to have a position larger than 5%.

Two problems for an index fund:

–someone has to choose which stock to exclude and thereby underweight, which introduces an element of active management into a product whose main selling point is that it has no active management (the obvious candidate, I think, to move outside is Amazon, but that only reduces the weighting of the protected box to 24.8%–which doesn’t fix the problem, since even a slight gain in one of the others likely renews the breach of 25%.)

–one alternative is to close the fund to new money, since the SEC rule applies to purchases, but even then how does the fund reinvest dividends paid by the 5%+ stocks?

To step back for a minute, the rationale for index funds is the combination of their low cost + the inability of active, high-fee managers in general to do better than the index on a consistent basis.

The only out for index funds, I think, is what has happened–they have notified their holders that they are no longer going to describe themselves as diversified in the technical sense of the 1940 Act.

What I think commentators have missed is that what has changed is not the character of the indexers, it’s the character of the index. It may well be that the stock market world is now a riskier place. But it doesn’t change the peculiar, but well-established fact that index funds virtually always outperform higher-cost actively-managed products, even before considering the latter’s much higher costs.