Like customers at an Apple store on the day a new iPhone is released, fund managers have crammed into large-cap tech stocks over the last six months as the world became reliant on work-from-home infrastructure.
In fact, 74% of hedge and mutual fund managers said in a recent July Bank of America survey that being long on large-cap tech stocks was the most crowded trade — the highest percentage in the survey’s history.
But as it turns out, that may have to change, at least for diversified mutual fund managers. It is not because of shaky fundamentals and investor exuberance, but because of Securities and Exchange Commission rules.
According to a September 10 note from Goldman Sachs, the valuation surges of companies like Amazon, Facebook, Microsoft, Apple, and Alphabet may have unwittingly put some fund managers in violation of SEC regulations.
The Investment Company Act of 1940 mandates that mutual funds labeled as “diversified” have no more than 25% of their portfolios made up of positions in individual securities that each exceed 5% of their assets.
Yet, that became the case for several diversified mutual funds as tech-stock valuations soared, Goldman Sachs found. For example, growth-fund managers are facing a situation where Apple, Microsoft, and Amazon now make up more than 5% of the Russell 1000 Growth Index’s market cap and collectively add up to 30%. This makes it challenging for managers to hold weights that are benchmarked to the indexes.
“Based on the most recent fund holdings data, 43 large-cap growth managers with $300 billion in AUM identify as ‘diversified’ but would currently fail the SEC’s limitations to register as a ‘diversified’ fund,” Goldman Sachs’s Chief US Equity Strategist David Kostin said in the note. “The average fund in this list holds 32% of its portfolio in individual positions that exceed 5% of its assets.”
Kostin laid out six strategies that “diversified” fund managers can follow to correct their course.
6 strategies for diversified fund managers to correct course
First, Kostin said one possibility — perhaps most obviously — is to sell holdings that are over the 5% threshold.
Still fund managers wouldn’t have to completely reduce their positions, and not every position would have to be brought below 5%, as long as at least 75% of them are.
He added that this likely wouldn’t have too large of implications for the broader market.
“The most conservative estimate assumes each fund meets the 5% ceiling on all positions. This approach implies $30 billion of assets would need to be sold by large-cap growth funds, representing around 0.2% of the total market cap of excess holding,” Kostin said.
He continued: “As long as these amounts were not sold immediately and all at once, the potential volume for sale would not be significant from a trading perspective, but inflows would also be affected given fund managers would already be at their 5% position limits.”
Second, Kostin said diversified growth fund managers might consider substituting holdings that are above the threshold with other US stocks that are similar in return potential and factor exposures.
Goldman used their “Marquee” platform to find stocks similar to the FAAMG grouping based on factor exposures.
Third, fund managers could turn to similar stocks listed on markets outside of the US.
Kostin recommends what he calls the Asia “Digital Dozen” as an alternative to US tech stocks based on their growth prospects, profit drivers, and valuations. These include: Alibaba; Tencent Holdings; TSMC; Samsung; Meituan Dianping; Reliance Industries; Sea Ltd.; NAVER Corp.; Baidu; TAL Education Group; New Oriental Education & Technology; and NCsoft Corporation.
Fourth, Kostin said fund managers could look to derivatives as a “substitute for cash positions that exceed diversification.”
“Assuming a fund is permitted to use derivatives, option strategies that could reduce tracking error for excess individual positions include buying calls, selling puts, or entering into total return swaps,” Kostin said.
Another possibility, he said, is to ask index providers to lessen the weighting of stocks over their five percent threshold. Kostin cited the 2011 example of the Nasdaq 100 index cutting Apple’s weight.
“As the owner of the [Russell 1000 Growth] index, [FTSE Russell] could decide to shift from an equity capitalization benchmark to a modified cap-weighted index,” Kostin said. “If the weighting of these large stocks was reduced, it would allow active managers more latitude in their allocations to these companies.”
Finally, Kostin said diversified fund managers can ask their investors if they would like to change the fund’s classification from “diversified.” He said Vanguard, among others, are currently in the process of doing this.