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Large investment funds run by firms such as Fidelity and T Rowe Price are being forced to offload shares to avoid getting into trouble with the US tax authorities, as this year’s lopsided stock market rally has pushed them up against strict limits requiring them to maintain diversified portfolios.
The Internal Revenue Service requires that any “regulated investment company” — which includes the vast majority of mutual funds and exchange traded funds — keep the combined weight of large holdings to less than 50 per cent of their overall portfolio. A large holding is anything that accounts for more than 5 per cent of assets.
Historically, the limit has mainly been a concern for specialist managers that run explicitly concentrated funds, but recent gains for the largest US tech companies means stockpicking investors that want to take even a slightly overweight position relative to an index in companies such as Nvidia and Microsoft are in danger of breaching the rules.
The trend highlights the unusual nature of the recent market rally, which has driven the S&P 500 and other indices to near-record levels of concentration. It also creates yet another challenge for active fund managers, most of whom have struggled to outperform surging indices.
Just five large companies — Nvidia, Apple, Meta, Microsoft and Amazon — have contributed about 46 per cent of the year-to-date gains for the S&P 500.
“It’s a very difficult situation for active managers,” said Jim Tierney, chief investment officer for concentrated US growth at AllianceBernstein. “Normally having a position at 6 or 7 per cent of your portfolio is as far as most portfolio managers would want to push it for a business you have real conviction in. The fact that would now be a neutral weight or even underweight, it’s an unprecedented situation.”
At the end of September, Fidelity’s $67bn Blue Chip Growth fund, which is benchmarked against the Russell 1000 Growth index, had more than 52 per cent of its portfolio in large positions — Nvidia, Apple, Amazon, Microsoft, Alphabet and Meta. BlackRock’s recently launched Long-Term US Equity ETF also had 52 per cent of its assets in holdings worth more than 5 per cent of the portfolio as of last week, according to data from Morningstar.
Funds are not immediately penalised if they go over the limit due to price rises alone, but once the threshold is passed they cannot add to the large holdings and would have to rebalance their portfolio if the fund received more inflows.
T Rowe Price’s $63bn Blue Chip Growth Fund has been over the 50 per cent threshold for six of the past nine months, but temporarily rebalanced its portfolio at the end of each quarter, when adherence to the IRS rule is checked.
There is also a grace period after the end of a quarter to rebalance portfolios, and so far no major funds have been penalised by the IRS. The IRS said it could not comment on individual taxpayer matters.
Stephen D D Hamilton, a partner at law firm Faegre Drinker who focuses on tax matters, said that the need to reshuffle holdings could drag on fund performance and trigger capital gains taxes.
“If you were dealing with highly concentrated positions, the cure might involve selling a lot of shares. It’s not ideal obviously,” he said.
Many more funds are running close to the 50 per cent limit, making it hard to add to their large holdings. The Ark Innovation ETF, for example, has 43 per cent of its assets in large holdings, and two more stocks that are close to the 5 per cent threshold at which they would also count towards the 50 per cent limit, but it has not exceeded the cap in more than a year.
The US Securities and Exchange Commission also has a separate, less strict diversification requirement that can be avoided by re-registering as a “non-diversified” fund. Breaking the IRS rule, however, would be much more damaging. The vast majority of funds register as regulated investment companies because of the tax benefits associated with them.
Losing RIC status would be “extraordinarily awful” for a fund, said Dave Nadig, a longtime ETF market expert.
Besides the immediate tax liability, a fund that lost its tax status without updating investors in a timely manner would also be at risk of punishment by the SEC.
A spokesperson for T Rowe said: “In an environment in which the benchmark is so concentrated, it helps to have a global research platform the size of ours, which allows us to find attractive ideas outside of the Mag 7 that can add alpha to our portfolios.”
A spokesperson for Fidelity said that the asset manager “always acts in the best interest of our shareholders and in doing so, routinely monitors our funds’ diversification as part of our compliance practices”.
BlackRock declined to comment. Ark did not respond to a request for comment.
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