Megacap dominance is starting to test mutual fund rules
As the biggest U.S. stocks take up more of the market, fund rules may limit how much managers can own, even when they like the companies.
By Priya Nair · Economy Reporter
· 3 min read
The biggest U.S. companies now make up a far larger slice of the stock market, and that changes the math for everyday investors who own mutual funds. A Klement on Investing analysis said the 10 largest U.S. companies have grown from 13% of total market value in 2015 to more than 30% roughly a decade later.
That concentration can raise portfolio risk if one of those megacap companies runs into trouble. It can also make it harder for the same stocks to keep getting larger inside regulated fund portfolios, according to research cited by the analysis.
Concentration means a small group of companies accounts for a large share of total market value. Market value, or market capitalization, is the stock price multiplied by the number of shares outstanding. When the biggest companies rise faster than the rest of the market, their weight in indexes and funds rises too.
Why fund rules matter
Many developed markets place limits on how concentrated mutual funds can be when they are sold to retail investors. In Europe, the Klement on Investing analysis pointed to the UCITS 5/10/40 rule. UCITS is the European framework for retail investment funds. In the U.S., the analysis cited the 50/5/10 rule.
Those rules matter because many fund managers are measured against a benchmark index, which is the market yardstick they try to beat. If a stock has a large position in the benchmark and a manager is optimistic about it, the manager may want to hold even more than the benchmark weight. That is called being overweight the stock.
Lubos Pastor and colleagues at the University of Chicago showed in a paper cited by the analysis that a concentrated benchmark can create a mechanical problem for fund investors. As the largest stocks move closer to regulatory position limits, bullish fund managers have less room to add to them. If a manager’s position approaches the 5% limit cited in the analysis, regulation can push the fund to sell or stop adding exposure even if the manager still likes the company.
That means sentiment and flows can split apart. A company may still have strong support from portfolio managers, while the rules governing retail mutual funds reduce how much those managers can own.
Index comparisons can mislead
The Klement on Investing analysis also cautioned against comparing the top-10 weight of the S&P 500 with indexes such as the FTSE 100 or the Swiss Market Index without adjusting for index size. The S&P 500 contains 500 companies, while the FTSE 100 contains 100 and the Swiss Market Index contains fewer.
Because the FTSE 100 and Swiss Market Index have fewer members, their 10 largest stocks will naturally account for a larger share of the index. The analysis argued that the smaller number of constituents is the key difference, rather than a clean sign that those markets are more concentrated in the same way.
The author of the Klement on Investing analysis argued that concentration rules serve a protective role. Citing experience from the late-1990s technology bubble, the author said many fund managers stayed positive on tech stocks after the bubble had already broken, and that looser rules could have allowed them to increase positions further.
For retail investors, the takeaway is about structure, not a trade call. As megacaps occupy more of the market, fund regulations can affect how much additional demand mutual funds can provide, even when the underlying companies remain popular with managers.
This story draws on original reporting from Klement on Investing.
