INVESTING EXPLAINED: What you need to know about fund concentration

In this series, we bust the jargon and explain a popular investing term or theme. Here it’s fund concentration. 

This sounds a bit boring…

You may have a point there, but fund concentration, although complex, is something you need to know about as it almost certainly affects the performance of your investments. The issue, which has been a source of confusion, is at the centre of a row.

The regulations covering fund concentration form part of a series of rules set out by the watchdog Financial Conduct Authority (FCA). 

These rules – which are designed to protect you – relate to OEIC (open ended investment company) funds in which savers have billions invested. They do not cover investment trusts which are closed-ended.

How do these rules work?

To avoid potentially risky concentration, funds cannot have more than 10 per cent of their portfolio invested in a single company. 

Common sense: To avoid potentially risky concentration, funds cannot have more than 10 per cent of their portfolio invested in a single company

Also individual holdings that each make up more than 5 per cent of the fund’s assets cannot together exceed 40 per cent of the fund’s assets. This is the ‘5/10/40’ rule. So a fund must have at least 20 holdings. It all sounds eminently sensible, but the rules are causing problems.

Why is that?

Nobody disputes the benefits of the diversification that the regulations should produce. But, suddenly this month, there has been a focus on their drawbacks. For example, many funds use a particular stock market index as their benchmark. In some cases, a major company, such as a giant tech group, may make up more than 10 per cent of the index, presenting a dilemma. Should managers comply with the rules, or try to achieve the best returns for investors?

Is anybody speaking out?

One of the most vocal critics is Terry Smith, manager of the £23billion Fundsmith fund. In an interview earlier this month, he described the system as a ‘headache’. 

Smith believes that the rules obstruct the operation of the fund, since they force him to concentrate less on delivering for investors than pleasing the FCA. He acknowledges that the rules are designed to protect investors, but says that he is being obliged to sell holdings purely to comply with the regulations.

Any other issues?

It has been reported that the popular five Vanguard Life Strategy funds – in which about £40billion of the nation’s savings is invested – may have breached the concentration limits. The LifeStrategy funds – which invest in funds that are also managed by Vanguard – have a 40 per cent stake in the Vanguard FTSE UK All Share index fund. Under a separate FCA rule, such umbrella funds are permitted to own a maximum of 25 per cent of such a ‘collective investment vehicle’. But it is not clear whether the FCA has granted Vanguard a waiver, causing a lot of comment on the way the rules are being implemented.

Vanguard has said it is satisfied with its approach after engagement with the FCA, but the latter’s silence adds to confusion.

This post first appeared on Dailymail.co.uk