Asset managers have called on the Financial Conduct Authority to change UCITS rules brought over from the EU to give active managers more freedom to invest in their best ideas.
Currently, active managers must adhere to the 5/10/40 rule, which states that a fund can hold no more than 10% in an individual stock. However, all the big holdings (identified here as anything over 5%) must add up to no more than 40% of the fund, meaning there can be a maximum of eight stocks with a 5% weighting.
This stops a fund from being too concentrated in a few large positions, even if each one stays under the 10% cap, but creates potential challenges for active managers to express their views if benchmarks themselves grow more concentrated – as they have in recent years.
Conversely, rules for passive funds are far looser. They can hold up to 20% in one company, a limit that can rise to 35% for a single stock, but only when justified by "exceptional market conditions".
Fidelity International runs both active and index funds. A spokesperson for the firm said: “We support active managers being able to fully express their conviction by being able to overweight stocks in an index. We would therefore welcome a regulatory change to align active and passive funds in this regard."
Others agreed the difference between the two sets of rules is worth considering in the current climate. Fabiana Fedeli, chief investment officer of equities, multi-asset & sustainability at M&G, said: “We do not see a clear rationale for applying different concentration caps to active UCITS and passive strategies.
“As both vehicles are designed to serve the same investors, including retail investors, then the foundational principles of risk diversification should be similar, whether less or more restrictive.”
She also called for better disclosure around passive funds that do not “adhere to reasonable diversification principles”. These should be “disclosed so that investors understand the nature of the exposure they are taking on”, she said.
“Greater transparency would help the end investor, particularly retail and smaller institutional investors, as we see large institutional investors growing increasingly more wary of index concentration.”
Richard Fox, head of public policy at Schroders, added: “Markets are changing, and current trends are resulting in increasingly concentrated benchmarks, with a small number of companies in the same sector and currency driving passive returns.
“This makes diversification essential and this is where active managers have real power to add value. We welcome any measures that provide greater flexibility to help us deliver the best possible outcomes for clients.”
Perhaps Taiwan Semiconductor (TSMC) is the most obvious example of this. The stock represents 15.5% of the MSCI Emerging Markets index, meaning active managers are forced to be underweight the stock – even if they like it, as one manager explained earlier this year.
Meanwhile, in the UK, banking group HSBC represents 10.5% of the FTSE 100 and 9.2% of the FTSE All Share index.
Nick Millington, head of Systematic Index Solutions at Aberdeen, noted that passive funds have more scope to hold larger single stock positions than active funds, which “creates a challenge for active managers”.
In particular, it hampers them “from using indexes with significant single stock concentration as a benchmark around which to construct an efficient portfolio in an index-relative risk sense”, he said.
“At one level the rule does make sense in that it helps maintain sensible levels of total risk for a given Sharpe ratio at the expense of tracking error and information ratio,” he said.
In other words, it keeps the risk-adjusted return in check (Sharpe ratio) at the expense of information ratio, which is a measure of how much extra return a manager generates per unit of tracking error to a benchmark. If the tracking error is low (because the fund cannot equally weight the index) then the figure is diminished in value.
“That outcome may be to the benefit of investors over the long term, but it is difficult to see why the same argument should not hold for passive investors managing to the same benchmark,” he said.
For Anna Macdonald, investment strategy director at Hargreaves Lansdown, there is scope to look at the UCITS rules, which she described as “worth considering” as there is “an intrinsic contradiction between how passive funds can behave and how active funds can behave”.
"I think it's a really interesting time to have a discussion about that. It's becoming a more and more live issue, isn't it?”
There have been discussions on UCITS rules in the past. In 2019, former FCA chief executive and current Bank of England governor Andrew Bailey told the Treasury Committee that the UK could review its application of the EU's UCITS regime post-Brexit.
He described the regime as "excessively rules-based", adding: “We will see about UCITS, frankly.”
In the meantime, Macdonald said it would fall on financial professionals to educate investors and explain why some funds own less of certain stocks, or to teach that index funds may not be as diversified as expected.
“What we would hope to do is to highlight the risks of both types – of what an index fund is trying to achieve and what an active fund is trying to achieve,” she said.
“We hope to talk to our clients about the risks of various different routes to market and I see that as being part of our role as a responsible platform, as it were. If most of our investors are choosing their own investments, [however] it's ultimately their decision.”
Earlier this month, Trustnet editor Jonathan Jones outlined why he believes active managers have suffered due to the current UCITS rules. In the next article of this series, Trustnet will look at how some passive funds and index-plus portfolios are being held back by the rules.