To stand a chance of winning in this market, stock pickers need big tech exposure. Not all of them can get it.

That’s because regulations dating back over 80 years set limits on how concentrated a “diversified” mutual fund can be. Under those rules, these funds must cap the number of individual securities that equal more than 5% of their assets, and such stakes can’t add up to more than 25% of their overall portfolios.

The problem is, Apple Inc. and Microsoft Corp. already make up more than 5% of indexes like the S&P 500 and Russell 1000. And the pressure to stay in compliance with the so-called diversification rules means many active funds have been underexposed to the megacap meltup and are therefore doomed to trail the market. 

“Having that blanket rule has been a very, very big challenge for the institutional management business because so few people have managed to outperform without owning some of these megacap stocks,” said Michael Sansoterra, chief investment officer at Silvant Capital Management. “That’s a handcuff.”

The blow is particularly harsh to money managers focusing on fast-growing companies, an area that’s ruled by tech giants. In the Russell 1000 Growth Index, the five largest members — also including Inc., Alphabet Inc. and Nvidia Corp. — this month each crossed the 5% threshold and added up to 40%, a total that if the benchmark were a diversified fund would put it in breach of the ownership limits.

While buying Faang stocks is not the only route to better returns, the performance of growth funds underscores the hurdle when such a small group of companies is driving broader gains.

Of the 126 funds that are benchmarked to the growth gauge, all but nine hold fewer Faang stocks than is indicated by the index, according to their latest regulatory filings compiled by Bloomberg. Their average return year-to-date is almost 5 percentage points behind peers whose holdings are above the benchmark.

The risk that funds might break rules by following benchmarks is one that has not gone unheeded by index compilers. The overseer of the Nasdaq 100, for instance, carried out a special rebalance this month to curb the influence of tech behemoths, a move intended to keep money managers who are linked or benchmarked to the index from violating a separate diversification rule.

“From our perspective, the motivation to reduce index concentration is purely from the regulatory angle,” said Cameron Lilja, vice president and global head of index product and operations at Nasdaq.

Repercussions from the ownership cap aren’t a trivial matter. Most mutual funds elect to be “diversified,” a status investors often associate with less risk and volatility. Such funds held about 92% of the industry’s $24 trillion of total assets as of 2020, according to a report by the Securities and Exchange Commission.

As recently as May, the average growth fund’s Faang stakes sat 15 percentage points below what’s suggested by the Russell index, an analysis by Goldman Sachs Group Inc. shows. While 74% of the funds are classified as “diversified,” 30% of them fail to meet the requirements.

Abiding by the rules is costly, according to the study. The median fund that is labeled as diversified while not meeting the diversification test has outperformed the benchmark by 1 percentage point this year. By contrast, those that are in compliance are behind by 7 percentage points.

These funds are “caught between a benchmark and a hard place,” Goldman strategist Cormac Conners said.

To be sure, these rules don’t force a fund to sell a stock once it breaches limits. In fact, the fund can keep an outsized allocation to these surging tech stocks. It just can’t make additional purchases — unless it reclassifies itself as “non-diversified,” a change that frees them to exceed the 25% ceiling.

That’s the path some are taking. Fidelity Growth Company Fund (ticker FDGRX) and T Rowe Price Blue Chip Growth Fund (TRBCX) are among those that won approvals in recent years from shareholders to make larger bets on individual stocks. Thanks in part to outsized exposure to Faang shares, each fund has returned 38% since January, compared with a 31% gain from the Russell growth index.

“These big stocks are really dominating the markets,” said David Cohne, a mutual fund analyst with Bloomberg Intelligence. “It’s made an issue of funds having a hard time to keep up unless they’re either not diversified or they’re letting their portfolios grow.”

In many ways, 2023 has been a year in which stock pickers have had a chance to shine. Share co-movements are falling and sector dispersions are widening, a benign setup that makes it easier to discern winners and losers. Yet with tech megacaps surging 80% on average — four times as much as the average stock in the S&P 500 — active managers are facing an uphill battle.

The diversification rules were established in 1940 to protect investors following the stock market crash and Great Depression. While the market has become more lopsided over time, punishing anyone who complies with the restrictions, BI’s Cohne doesn’t expect the regulations to ease any time soon.

“If you have a portfolio that’s dominated by only a few names, it becomes a lot more risky,” he said. “These rules are in place for a reason so that investors don’t lose out.”

--With assistance from Brad Skillman and Sam Potter.

This article was provided by Bloomberg News.