An unexpected surge in tech stocks is causing prominent US investment funds to collide with regulations that ensure asset diversification. Tech stock domination in prominent indices has taken these funds to their regulatory maximums, indicating that the ongoing tech rally is not without its hurdles for investors and index providers.
A lofty rally with complications
The technology sector has delivered a noteworthy performance, yet the rally is increasingly uneven. The S&P 500 index experienced an 18% rise this year, largely driven by seven heavyweight tech stocks.
This dominance is compelling index providers like Nasdaq 100, synonymous with soaring tech stocks, to reevaluate their structure to curtail the impact of giants like Apple, Microsoft, and Nvidia.
Unsurprisingly, this tech stock surge has affected mutual fund specialists, including American Century, BlackRock, Fidelity, JPMorgan Asset Management, and Morgan Stanley Investment Management.
All of these players are now encountering stringent regulations dictating fund diversification. A diversified fund, registered with the Securities and Exchange Commission (SEC), is limited to investing a maximum of 25% of its assets in large holdings.
Large holdings refer to stocks making up over 5% of the fund’s portfolio when initially invested. While funds can maintain their current stocks if the value rises beyond the 25% threshold, they cannot purchase additional shares once the limit is reached.
Regulations and the response
In May, the tech stock rally meant that Fidelity’s $108bn Contrafund was unable to purchase more shares of Berkshire Hathaway, Meta, Microsoft, and Amazon, as these stocks collectively represented 32% of its portfolio.
The same month, BlackRock’s Technology Opportunities Fund hit its limit for Apple, Microsoft, and Nvidia shares. Meanwhile, index-mimicking funds like those tracking the Russell 1000 Growth Index are similarly exceeding limits due to the concentration of tech stocks.
Although the SEC stated in 2019 that it would not strictly enforce the 25% limit on passive funds tracking an index, this restriction complicates matters for active managers looking to capitalize on the tech rally.
With funds striving to remain compliant, strategies are shifting. Some, like T Rowe Price, have transitioned their funds to “non-diversified” status, enabling more concentrated investments. However, such moves necessitate shareholder approval and could dissuade clients fearing high-risk exposure.
Stephen Cohen, a partner at law firm Dechert, suggested that funds breaching rules would most likely be steered back into compliance by the SEC. Funds losing money while in breach may also face potential lawsuits from investors.
Index providers, too, are grappling with the tech stock juggernaut. Nasdaq, faced with similar pressure to diversify, announced earlier this month changes to its Nasdaq 100 index.
Large holdings, presently constituting 50% of the index, will be reduced to 40% to ensure funds tracking the index continue to meet regulated investment company requirements.
The US funds’ struggle to keep pace with the tech stock frenzy illuminates a fascinating yet complex narrative. As the technology sector continues its ascend, these regulatory challenges provide a unique insight into the machinery behind market operations.
