How fund rules can make some pros forced sellers when a stock soars

When it comes to funds and investment trusts, some hold a small number stocks, while others own hundreds. However, the middle ground is more common, with around 40 to 80 positions.  

While there’s no magic number of stocks that helps a fund manager gain an edge, there are rules to ensure funds have sufficiently diversified portfolios.

• Our Services: SIPP Account | Stocks & Shares ISA | See all Investment Accounts

The European Union’s UCITS rules, a regulatory framework for funds sold to investors in Europe, stipulate that holdings accounting for more than 5% of a fund’s portfolio cannot collectively account for more than 40% of the fund's overall holdings. In addition, UK fund rules prohibit an individual holding exceeding 10% of a fund’s total assets, while investment trusts do not have a 10% limit. The regulation is known as the “5/10/40” rule.

Bear in mind that some funds are considered non-UCITS retail schemes, such as Lindsell Train UK Equity, so they have more lenient rules in terms of portfolio concentration, but the 10% single-stock limit still applies as it is an open-ended fund.

These fund rules can turn some fund managers running concentrated portfolios into forced sellers when one of their top positions has a purple patch.

One example, highlighted in our latest On The Money podcast, is from Blue Whale Growth fund, managed by Stephen Yiu. The fund, which has 29 holdings, has this year been forced to twice take profits in Nvidia (NASDAQ:NVDA) to keep below the 10% limit. Year-to-date, Nvida’s share price is up over 200% due to it being seen as the star stock to play the artificial intelligence (AI) theme. Nvidia manufactures the computer chips that leading AI systems are developed and implemented on.

Yiu explained: “This year we were forced to trim our position in a very small way since Nvidia become a trillion dollar company. And, of course, the strategy we are running is a UCITS strategy, so no single position can be more than 10%.

“It does cause us some issues...when you look at artificial intelligence, which is something we are very positive about today for the foreseeable coming years. There are only a handful of companies [where] you can get the right amount of exposure.”

Yiu added: “You do not have another five Nvidias out there. So, it is an issue that we are limited to 10%, as it is not like we can find another three to five companies that would have the same dynamics.”

• Why 2023's biggest stock market story has staying power
• ii view: Nvidia beats forecasts but cautious on China

Yiu added that he thinks there will be “fewer opportunities” to find companies that are well placed to weather the prevailing economic backdrop.  

“We think  that in next couple of years we [face] a new regime, with geopolitical uncertainty, the oil price being quite steady at a high level, inflation remaining sticky, [and] there are not many businesses out there that can transcend the macro uncertainties. 

“If you can continue to sell products and services irrespective of the headwinds out there, that’s great, and we have invested in those companies like Nvidia and Microsoft Corp (NASDAQ:MSFT). But there are just not many of those businesses. 

“Going forward, [there’s] fewer opportunities to invest into compared to the last couple of years, which makes the rule quite stringent in terms of the outperforming potential we can deliver.”

Also in the interview, Yiu explains why the AI theme has plenty of staying power in the years ahead, reveals that he is revisiting buying back into Meta Platforms (NASDAQ:META), and gives his outlook for global equities in 2024.

Another fund manager who recently spoke out about fund concentration rules was Terry Smith of Fundsmith Equity.

Giving a half-year update on his strategy to MeDirect Bank, a Maltese bank, he said that the strong performance of some his biggest positions was giving him a “headache”.

Smith said: “One of the things that we have to deal with are the concentration portfolio rules, which obviously we’ve got to follow. We have our own ones and the mandated ones for an OIEC[open-ended investment company].

“We quite often find ourselves having to sell things because they are affecting our holdings over 5%. We can’t have more than 40% in companies that are over 5% of the portfolio.”

As a consequence, he says that there are days where he ends up taking money out of a company, not because he wants to, but because of the concentration rules.

• Fund group holding hurts Lindsell Train trust performance
• Still time to buy, or too late to profit from the best market since Covid?

Smith said: “They [the rules] are there to protect people. But I do find it a bit strange that as a fund manager I can come in worrying that my best or biggest stocks will perform well. Is this right? I am not sure this should be exactly how I am led to think about this portfolio; that my biggest stocks are performing well and I’ve got a headache.”

Moreover, a consequence for certain active funds is that it makes it tougher to beat index funds and exchange-traded funds (ETFs) when large stocks keep becoming larger, as is the case with the so-called Magnificent Seven tech stocks. Those seven stocks now account for around 30% of the S&P 500 index.