UCITS rules that cap how much an active fund can own in any one stock risk pushing fund managers into riskier holdings if companies go above this limit, one fund manager has warned.
Current regulations dictate that active funds under the UCITS umbrella cannot own more than 10% in a single stock, while no more than 40% of a portfolio can be made up of holdings above a 5% weighting.
The 10% portion of the rule has been a pressing issue in Asia and emerging markets, where semiconductor stock Taiwan Semiconductor Manufacturing Company (TSMC) dominates and is now some 15.6% of the MSCI Emerging Markets index.
Active fund managers are forced underweight the company, a situation that Leon Eidelman, co-manager of JPM Emerging Markets, said could make portfolios riskier.
“Obviously, the goal for the regulator is to protect investors from overly concentrated funds,” he said. As a result, in emerging markets active managers are finding ways around being underweight.
Last week, for example, Chris Lo, head of research-enhanced strategies at Columbia Threadneedle, said his emerging market fund invests with sector- and country-neutral allocations.
As a result, he has used the relative underweight to put money into the likes of Samsung Electronics and SK Hynix, two South Korean companies in the semiconductor space that have performed strongly in recent years.
However, Eidelman has warned that this approach can lead to riskier portfolios, as managers crowd into other tech names and Taiwanese stocks that may not be as attractive as TSMC.
“What ends up happening is they buy a basket of smaller names and so subsequently the valuation for those smaller names goes up a lot more. And so you’re actually left with a somewhat riskier portfolio,” he said.
As an example, he said if TSMC is on a price-to-earnings ratio of 20x and a fund manager is 5 percentage points short of the index weight, they may have to replace it with a basket of, say, five stocks that “everybody’s crowding into” that trade on an average P/E of 35x.
“Then you look at the correlation of returns for those stocks and it turns out that their correlation to each other is higher than it’s ever been, which basically tells you that they’re really trading as one stock,” he said.
“So eventually, when the markets come off, those small stocks hurt a lot more because people have crowded into them and because they trade at a meaningfully higher multiple than TSMC.”
In this scenario, TSMC may drop from 20x earnings to 16x. While this is “not pleasant”, Eidelman said it is manageable. Meanwhile stocks on 35x earnings could also drop to 15x earnings as people crowd for the exit.
“So you do have this situation today where the knock-on effects of the limit could well be leading to a riskier portfolio, which is obviously not what was originally intended,” he said.
This could be a problem for many, as last week he told Trustnet he would be “quite shocked” if people were not near their full allocation to TSMC. Indeed, we found that 71 of 119 active funds – around 60% – hold some combination of TSMC, Samsung Electronics and SK Hynix as their top three holdings.
Trustnet launched its conviction cap campaign last month, backed by asset managers, urging the Financial Conduct Authority (FCA) to review current UCITS rules. You can find more reading on our campaign here.