June 16, 2024

S&P 500, Dow trade at record high as stock rally continues

Bloomberg’s Lu Wang is out with a great story this morning chronicling the challenges facing active managers in an environment where a few megacap companies are powering the index to record highs.

The basic problem is basic math — with the “Magnificent Seven” stocks accounting for about a 30% weight in the S&P 500 and investors prevented from holding those stocks in this proportion, keeping up with the benchmark index cannot be done by matching the benchmark. Now, of course, mutual fund mangers could stuff their funds with ETFs that track the S&P 500. But that’s not why investors pay the stepped-up fees charged by active funds.

At issue, specifically, is the Investment Company Act of 1940, which governs how actively managed stock funds can behave.

As Morningstar’s Robby Greengold wrote last year, the law “implies that an allocation of 5% or more to a single security is uncomfortably large; to earn the diversified status, a mutual fund must limit the aggregate share of such positions to 25% of its assets.”

In Section 5, specifically, the act states:

“Diversified company” means a management company which meets the following requirements: At 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 the 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 of such management company and to not more than 10 per centum of the outstanding voting securities of such issuer.

Basically, your fund needs to be mostly liquid, the investments spread widely, and remain mostly passive as it relates to the management of the companies invested in. And this final piece offers another notable wrinkle for the active fund management community.

Most investors using mutual funds to allocate capital probably aren’t looking to become activist investors. But, if they were, these rules preclude this possible strategy wrinkle. Just another way the investment world is a treacherous place for stock pickers.

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