Some mutual funds are legally diversified and some are not, and the line between them is drawn by federal statute, not marketing. Under the Investment Company Act of 1940, a fund can only call itself a diversified mutual fund if it satisfies a specific mathematical test known as the 75-5-10 rule. Everything else is classified as nondiversified. So the honest answer to whether mutual funds are diversified is: some are, some aren’t, and even the ones that are can hold larger single-company bets than most investors assume.
What “Diversified” Actually Requires
Under 15 U.S.C. § 80a-5, a diversified company must keep at least 75% of the value of its total assets in a combination of cash, government securities, securities of other investment companies, and other securities.1Office of the Law Revision Counsel. 15 USC 80a-5 – Subclassification of Management Companies Within that 75% bucket, the “other securities” portion is capped at 5% of total assets in any single issuer and 10% of that issuer’s outstanding voting shares. Government securities and investment company securities inside the 75% bucket aren’t subject to those per-issuer caps.
The remaining 25% of the portfolio has no comparable per-issuer restriction under this statute. In theory, a diversified fund could put a large chunk of that 25% into a single company and still be legally diversified. That is the piece most investors miss when they see the word on a fund’s cover page.
What the Label Doesn’t Prevent
The 75-5-10 test applies at the moment of acquisition, not continuously. A stock that was 4% of a portfolio when purchased can grow to 8% during a strong run without stripping the fund of its diversified status. Section 5(c) of the Investment Company Act protects the fund as long as the discrepancy wasn’t caused by a new purchase.1Office of the Law Revision Counsel. 15 USC 80a-5 – Subclassification of Management Companies A 2022 SEC staff report to Congress confirmed this reading, stating that a diversified company “adversely affected by market movements will not lose its diversification status, so long as any discrepancy existing immediately after an acquisition of assets is neither wholly nor partly the result of such acquisition.”2U.S. Securities and Exchange Commission. Staff Report to Congress Regarding the Study on Threshold Limits Applicable to Diversified Companies
The practical result is that a nominally diversified fund can carry individual positions well above 5% of assets. The status only breaks if the manager actively buys more shares while the position already exceeds the threshold.
Nondiversified Funds
The statute defines a nondiversified company simply as “any management company other than a diversified company.”1Office of the Law Revision Counsel. 15 USC 80a-5 – Subclassification of Management Companies These funds can legally hold more than 5% of their assets in a single issuer and can own more than 10% of a company’s voting stock. Sector-focused funds and index funds tracking narrow slices of the market often use this classification, because the 75-5-10 rule would prevent them from holding the concentration their strategy requires.
Nondiversified funds have to say so. SEC Form N-1A requires them to state in their prospectus that they are non-diversified, explain what that means in practical terms (such as holding a larger share of assets in individual companies compared to diversified funds), and describe the additional risks that concentration creates.3U.S. Securities and Exchange Commission. Form N-1A
A Fund Can’t Quietly Switch
Under 15 U.S.C. § 80a-13, changing from diversified to nondiversified requires approval by a majority of the fund’s outstanding voting securities.4Office of the Law Revision Counsel. 15 USC 80a-13 – Changes in Investment Policy Reclassification changes the risk profile, and shareholders get a vote. In 2025, Vanguard asked shareholders of two index funds to approve reclassification from diversified to nondiversified so the funds could more accurately track their sector-specific benchmarks without bumping against the per-issuer caps.
Industry Concentration Is a Separate Question
Per-issuer diversification is not the same thing as industry diversification. Every mutual fund must adopt a fundamental investment policy on whether it will concentrate in a particular industry, and the SEC treats holding 25% or more of total assets in a single industry as concentration.5U.S. Securities and Exchange Commission. Proposed Rule – Investment Company Names A fund could meet the 75-5-10 rule perfectly by spreading its holdings across dozens of issuers and still be concentrated in one industry. Once a fund states its concentration policy in its registration documents, changing that policy also requires a shareholder vote.
The Tax Code Adds Its Own Diversification Test
Meeting the Investment Company Act’s definition is only half the picture. The Internal Revenue Code imposes a separate diversification test that every mutual fund must pass to qualify as a Regulated Investment Company under Subchapter M. A fund that fails this test gets taxed like a regular C corporation, meaning fund-level income tax before anything reaches shareholders.
Under 26 U.S.C. § 851(b)(3), a fund must satisfy two asset requirements at the close of each quarter. At least 50% of total assets must be in cash, government securities, other RIC securities, and other securities, with per-issuer limits of 5% of assets and 10% of voting securities within that bucket. And no more than 25% of total assets may be invested in the securities of any one issuer, excluding government securities and other RICs.6Office of the Law Revision Counsel. 26 USC 851 – Definition of Regulated Investment Company That 25% single-issuer cap is the tax code’s hard ceiling and applies to the whole portfolio, not just part of it.
These thresholds differ from the 1940 Act rule. The 50% diversified bucket is smaller than 75%, but the 25% single-issuer cap has no equivalent in the 1940 Act’s framework for the unrestricted portion. In practice, both tests constrain portfolio construction at the same time. If a position drifts past the tax limits due to market appreciation rather than a purchase, the fund keeps its RIC status. If a purchase causes the breach, the fund has 30 days after the end of the quarter to cure it.6Office of the Law Revision Counsel. 26 USC 851 – Definition of Regulated Investment Company
How to Check a Fund’s Classification
The fastest way to confirm what you own is the prospectus. Funds must deliver one before the initial purchase, and it must disclose the fund’s classification, its concentration policy, and the principal risks tied to its strategy.3U.S. Securities and Exchange Commission. Form N-1A For nondiversified funds, that includes the possibility that a decline in one or two large positions could disproportionately affect the fund’s value.
To see the actual holdings, use Form N-PORT, which replaced Form N-Q in 2020. Funds report portfolio data monthly, filed on a quarterly basis within 60 days after each fiscal quarter ends.7U.S. Securities and Exchange Commission. Investment Company Reporting Modernization Rules These filings are on the SEC’s EDGAR system, and anyone can pull them up to see whether the actual holdings look diversified.
Owning Several Diversified Funds Is Not the Same as Being Diversified
A portfolio of diversified funds can still be concentrated. Managers building to similar benchmarks end up holding many of the same large-cap stocks, and the overlap can be substantial. If three funds in your retirement account each devote 5% of assets to the same tech company, your personal exposure to that company is far larger than any single fund’s position implies.
The overlap problem is especially common among funds tracking broad market indexes, where the biggest companies by market value dominate the top holdings of every fund in the category. One tool for gauging this is “active share,” which measures the percentage of a fund’s holdings that differ from its benchmark. A fund with an active share of 60% holds 40% of its portfolio in positions identical to the benchmark. Two funds benchmarked to the same index with low active shares will have heavy overlap, even if each individually satisfies the 75-5-10 rule. Pulling up the top-10 holdings of every fund you own and comparing them is the fastest way to spot the concentration a stack of “diversified” labels can hide.