Diversified vs Nondiversified Funds

[Admin/YBB]

DIVERSIFICATION 75-5-10 rule (ICA 1940) refers to the requirement that 75% of the fund assets have less than 5% of fund assets in each holding and less than 10% of the outstanding shares of any holding; the Rule is applied/tested over multiple years and the SEC has issued exceptions for accidental violations. A fund with less than 100 holdings may be NONDIVERSIFIED. The IRS also has diversification rules for tax purposes – a 2-part rule that is (i) 50-5-10, i.e. 50% of the fund assets are limited to 5% of fund assets in any holding and 10% of outstanding shares of any holding, and (ii) up to 25% of the fund assets can have controlling interest in one or more holding. The original intent was so that funds couldn’t just keep money in cash or used primarily as controlling entities. But now we see a strange application of this rule. For example, a broad index such as large-cap-growth (LC-growth) has such a high concentration in IT that it used the 25% exception for those concentrated positions and still claimed to be diversified by meeting the 75-5-10 Rule for 75% of the fund assets; but this has changed recently and LC-growth index has become nondiversified. Active LC-growth funds can make adjustments to remain diversified but some LC-growth funds have just switched to being nondiversified.

Nondiversified large-cap-growth ETFs include MGK; IWF, VONG, VUG; IVW, VOOG, etc.

As many ETFs (passive and factor-based) use customized indexes with smaller number of holdings, they may be nondiversified.

Edit/Add: All M* 9-boxes (broad) categories (LCV, LC, LCG; MCV, MC, MCG, SCV, SC, SCG) are diversified EXCEPT LCG.

Securities CE securitiesce.com/definitions/6113-75-5-10-diversification/
SEC www.sec.gov/files/staff-report-threshold-limits-diversified-funds.pdf
SEC Relief www.jdsupra.com/legalnews/sec-provides-no-action-relief-for-index-74342/
Cornell Law www.law.cornell.edu/uscode/text/15/80a-5
Cornell Law2 www.law.cornell.edu/cfr/text/17/270.13a-1

[Admin/YBB]

Reply to related post at M*:
community.morningstar.com/s/question/0D53o000067lC6dCAE/many-lcgrowth-funds-are-nondiversified

yogibearbull
(Customer)
a few seconds ago (6/26/22)

@jrlfunds (Customer)​ , the 1st test is simple:
Add up all % of fund holdings that represent 5%+ of the fund AUM, and if that sum is greater than 25%, then the fund is nondiversified.

2nd test is less simple because the data about % of outstanding shares of portfolio companies is less easily available (but can be found). That test would be:
Add up all % of fund holdings that represent 10%+ of company shares outstanding, and if that sum is greater than 25%, then the fund is nondiversified.


Either test is enough. So, use the 2nd test only when the 1st test is inconclusive but you suspect that the fund may be nondiversified. In all of examples in the OP, the 1st test was enough and I also double-checked some fund prospectuses or SAIs.

Frankly, it is so easy to jigger things so that the fund can remain diversified. Index funds have no choice when their indexes become nondiversified, but active funds that simply change to nondiversified status (because their benchmark indexes became nondiversified) are the lazy ones or closet-indexers.