The Financial Conduct Authority’s response to calls for a consultation into the current UCITS rules has been labelled “incautious” by Gervais Williams, who has said the City watchdog “must be a tiny bit embarrassed”.
It comes in response to Trustnet’s conviction cap campaign to get the FCA to look into UCITS rules retained from Europe in the post-Brexit era. The main issue centres around the 5/10/40 rule, which states that a fund can hold no more than 10% in an individual stock and can have no more than 40% in stocks that take up more than a 5% position. Index-tracking funds, however, are permitted up to 20% in an individual stock, and this can rise to 35% in exceptional circumstances.
Yet the rules impact some passive funds too. Any that do not use full physical replication (buying each stock individually) are held to the same rules as active funds, as Invesco head of EMEA ETF product Matt Tagliani told Trustnet. Meanwhile, any quantitative funds aiming to provide benchmark-like returns with incremental gains on top are also hamstrung by these rules as, in some cases, they are unable to use the benchmark weighting.
This is becoming a larger issue in the current climate, as AI winners have ballooned in size and dominate certain markets. TSMC in emerging markets and Asia sectors is a prime example.
However, it is not just an AI phenomenon. In the UK, banking giant HSBC now makes up more than 10% of the FTSE 100, meaning managers who like the stock are prohibited from taking an overweight position.
As a result, asset managers from both the passive and active sphere have called for action. However, Trustnet understands the City watchdog is not currently consulting on, nor does it plan to consult on, changes to the current UCITS rules. This is despite acknowledging the differing views across the asset management industry.
In response, an FCA spokesperson said: “The FCA's authorised fund rules are designed to support an appropriate spread of risk for retail investors. For UCITS funds, this includes diversification requirements that limit exposure to individual issuers and help protect consumers from excessive concentration risk.
“The rules include specific provisions for index-tracking funds, recognising that some benchmarks are concentrated and that funds seeking to replicate them may require additional flexibility.
“We recognise there are differing views across the industry on the current framework. Any potential changes would need careful consideration against our statutory objectives and would be subject to consultation."
But this was not satisfactory for some. Gervais Williams, chair of equities at Premier Miton, said the City watchdog was being “a bit incautious”.
“In fact, they must be a tiny bit embarrassed by that answer internally, one assumes, because their responsibility is very much about the good order of markets and making sure people can trust the markets and so on. But they're not recognising just how extreme some of the recent trends have been, and therefore how much more unsettling a reversal of that extremity would be,” he said.
He highlighted that correlation risk between large-caps around the world has become “extraordinarily large” and in a more normal environment would be deemed excessive.
“But whilst they're making so much money, people aren't underperforming, so they're happy to slightly overlook it,” he said.
Stock-specific risk is also “way out of [its typical] range”, adding that a lot of DIY investors will be unaware of the risks that passive investing carries.
This is a topic close to Williams’ heart, as he wrote a book 15 years ago called Slow Finance: Why Investment Miles Matter, in which he argued that investing is like the food industry and funds are like a meat pie.
Twenty years ago, people just bought a meat pie, now they read the label to see what is in it. The same should be true of investing, but we remain stuck in the past.
“When we buy a fund, we just think, 'Oh, this is a top-performing fund, marvellous, I'll buy that,' and then we'll go and buy a world-leaders fund as well, which contains lots of the same US names, and then maybe a fund that's a sort of double-beta play on top of that, which also contains lots of US investments,” he said.
“So you've got this nightmare of correlation at the moment, because – like before the slow food movement – you haven't actually looked at the ingredients.”
He likened the current situation to the one investors faced with Vodafone in the early 2000s, when the telecommunications company briefly became the largest stock in Europe and was worth around 13% of the FTSE All Share before its shares collapsed by around 75% from peak to trough.
“I’m not saying SpaceX or Nvidia won't carry on going up; I don't know. But what I do know is that the behaviour and the correlation risk is, I'd argue, more severe now than it was during the dot-com era. So this is a massive issue that the FCA should definitely look at,” he concluded.