by Melissa R. Brown, CFA
Yet another issue has recently cropped up, leading to unique challenges for investors in the current market environment — the impact of SEC diversification rules, which until now have not had a substantial portfolio impact.
My colleague Diana Baechle recently wrote a blog post detailing the substantial impact of the FAANG stocks on risk and return in the US market (see “The US market can thank its FAANGS”). That prompted our new colleague Ping Jiang to cite the SEC concentration rule for diversified mutual funds, which states that the top four stocks in a portfolio may not comprise more than 25% of an active portfolio. (The rule does not hold for concentrated funds or index funds). The recent surge in the biggest names in the Russell 1000 Growth index (not all FAANGs[1]) has increased their aggregate weight to well over that limit, for the first time in the history of our data.
If active growth managers with this benchmark are limited in how much weight in these names they can hold, we surmised that capping the weights would have a substantial impact on their portfolios, specifically their ability to outperform. To test this, we created a parallel portfolio back to 1982 that capped each name proportional to its weight, so that the top four weights totaled no more than 25%[2]. We wanted to see how often the cap was reached and what impact the capping requirement had on risk and performance. Results were not what we expected. Our findings:
First, using month-end holdings, this barrier was breached only once before this year—in May 2001—and the aggregate weight of the top four stocks was only 20 basis points above the limit. Subsequently, the top four stocks in the Russell 1000 Growth remained below 25% in aggregate weight until January of 2020, when they again slightly topped it. By June, however, those big names accounted for more than 32% of the index, and substantial trimming would have been required. (Note that positions can drift above 25%, so active managers do not have to explicitly trim them. They just cannot add to them until the total weight falls below the 25% threshold. This makes actively managing the biggest positions in a large-cap growth benchmark difficult.)
Second, even though these stocks’ positions would have had to be cut, the impact on performance so far this year was relatively small. Performance of the portfolio with capped weights was roughly 20 basis points below that of the index. (Of course, if the weight-capping had not been proportional and instead, say, only Amazon’s weight was cut, the performance impact could have been much bigger.)
Third, and possibly most surprising, was the impact on active risk caused by capping the weights. By the end of July, the tracking error between the portfolio with capped weights and the underlying index was more than 1.3%. For an active manager with a Russell 1000 Growth benchmark, that is a lot of active risk to take on before implementing any of his or her views. Requiring an underweight in those names suggests the other portfolio bets would have to generate even higher payoffs for the manager to outperform.
[1] Apple, Microsoft, Amazon and Facebook as of July 30, 2020.
[2] Many thanks to our colleague Walter Wang for creating these portfolios and running the detailed analysis.
