Concentration Limits for Mutual Funds and Retirement Plans

Concentration limits for mutual funds and retirement plans are the federal rules that cap how much of a fund’s or plan’s assets can sit in a single issuer, industry, or asset class. They come from four different bodies of law working in parallel: the Investment Company Act of 1940 sets the diversification test for mutual funds, Subchapter M of the Internal Revenue Code adds a tax-qualification test, SEC Rule 2a-7 tightens the rules for money market funds, exchange listing standards govern ETFs, and ERISA controls how much employer stock a pension plan can hold. Each layer answers a different question, but they share one purpose: no single bet should be large enough to sink the whole portfolio.

The 75-5-10 Rule for Diversified Mutual Funds

A mutual fund that calls itself “diversified” has to satisfy Section 5(b)(1) of the Investment Company Act. At least 75% of the fund’s total assets must be held in cash, government securities, securities of other investment companies, and other securities. Inside that 75% slice, no more than 5% of total assets can sit in the securities of any single issuer, and the fund cannot own more than 10% of any one issuer’s outstanding voting securities.¹

The other 25% is unrestricted by this test. That block is where a manager can take larger positions in a favored company or sector without losing the diversified classification.

U.S. government securities sit in their own category and are not subject to the 5% issuer cap. A diversified fund could hold 40% of its assets in Treasury bonds and remain in compliance, because those bonds are counted separately from the “other securities” bucket where the per-issuer limit applies.¹

When the Test Is Applied

The 75-5-10 thresholds are checked at the moment the fund acquires a security, not continuously. If a stock later appreciates and pushes the fund past the 5% ceiling for that issuer, the fund does not automatically lose its diversified status. Section 5(c) of the 1940 Act protects passive breaches: the fund keeps its classification so long as any post-acquisition discrepancy was not caused by the acquisition itself.¹ Trouble arises only when the fund deliberately buys more of an issuer while already over the limit.

A fund that crosses the line through its own purchases may have to reclassify as non-diversified in its SEC filings. That change requires shareholder approval, so it is not something fund managers do casually.

Industry Concentration

Section 8(b)(1) requires every fund to disclose whether it reserves the right to concentrate in a single industry. The SEC treats investing more than 25% of total assets in one industry as “concentrated.” Most diversified funds adopt a fundamental policy against that, and changing a fundamental policy requires a shareholder vote.

The Tax Test for Regulated Investment Companies

Passing the 1940 Act’s test is only half the picture. To avoid corporate-level tax, a fund must also qualify as a regulated investment company under Subchapter M. Section 851(b)(3) imposes its own diversification test, checked at the close of every quarter, with two prongs that operate together.

The 50% Prong

At least 50% of total assets must consist of cash, government securities, securities of other RICs, and other securities. Within the “other securities” portion of that 50%, the same per-issuer limits apply: no more than 5% of total assets in any one issuer, and no more than 10% of that issuer’s outstanding voting securities.²

The 25% Single-Issuer Cap

The second prong restricts the other half. No more than 25% of total assets can be invested in the securities of any one issuer, excluding government securities and other RICs. The same 25% ceiling applies to two or more controlled issuers in the same or related businesses, and to qualified publicly traded partnerships.² This prong catches what the 50% prong misses. Without it, a fund could theoretically park 49% of assets in a single company’s stock and still pass.

Cure Periods

Because the Section 851 test is checked quarterly, market movements can create genuine failures. A fund that passes at one quarter-end but drifts out of compliance later does not lose RIC status unless the discrepancy exists right after an acquisition and was caused by that acquisition. If a purchase does create the problem, the fund has 30 days after the quarter’s close to fix it.

For failures outside the 30-day window, broader relief keeps RIC status intact if the failure was due to reasonable cause and not willful neglect, the fund identifies the offending assets, and it either disposes of them or returns to compliance within six months. A separate de minimis exception covers failures involving very small amounts. Losing RIC status triggers corporate-level tax on the fund’s income and effectively double-taxes shareholders, so these cure provisions get used aggressively.²

Money Market Fund Limits Under Rule 2a-7

Money market funds operate under tighter rules because they are marketed as near-cash. A taxable or national money market fund generally cannot invest more than 5% of total assets in the securities of any single issuer. A narrow exception allows up to 25% in a single issuer for up to three business days after acquisition, and only for one issuer at a time.³

Rule 2a-7 also caps exposure to any single guarantor or demand-feature provider at 10% of total assets. Money market funds often hold commercial paper backed by bank guarantees, and without this limit a fund could hold paper from dozens of different issuers all guaranteed by the same bank.³

For asset-backed securities, Rule 2a-7 looks through to the underlying obligors. Any entity responsible for 10% or more of the principal amount of the qualifying assets is treated as an issuer of its proportional share, so the 5% concentration limit applies to the major obligors underneath, not just the packaging vehicle.

ETF Concentration Under Exchange Listing Standards

ETFs face concentration requirements imposed by the exchanges where they trade rather than by the SEC’s fund-level rules. For passive equity ETFs listed on Nasdaq, the heaviest-weighted component stock in the underlying index cannot exceed 25% of the index weight, and the five heaviest-weighted stocks together cannot exceed 60%. Fixed-income indexes get more room: no single component above 30%, and the top five capped at 65%.⁴

Actively managed equity ETFs get slightly more flexibility. Nasdaq permits the heaviest-weighted equity holding in an active ETF to reach 30% of the equity portion, with the top five capped at 65%.⁵ These standards keep even broad-market ETFs from becoming proxies for a handful of mega-cap stocks. A fund that falls out of compliance risks delisting or forced rebalancing.

One boundary worth noting: SEC Rule 6c-11 governs the operational framework for ETFs (daily portfolio disclosure, custom basket policies, website transparency) but does not itself set the concentration caps. Those come from the exchange listing rules above.⁶

Employer Stock in Retirement Plans

ERISA takes a different angle. Instead of capping outside issuers, it targets the concentration that hurts employees most directly: retirement savings tied to their own employer.

The 10% Cap on Employer Securities

Traditional defined benefit pension plans generally cannot hold more than 10% of assets in employer securities or employer real property. The limit is measured by fair market value and applied immediately after any acquisition. If buying a block of company stock would push the plan past 10%, the acquisition is prohibited.⁷ A breach exposes plan fiduciaries to personal liability and can force divestment of the excess.

Why 401(k) Balances Can Be All Company Stock

Individual account plans (401(k)s, profit-sharing plans, stock bonus plans) are exempt from the 10% rule. The statute calls them “eligible individual account plans,” and they can hold employer stock well beyond 10% if the plan documents allow.⁷ That exemption is why some 401(k) participants end up with half their balance or more in company stock, especially where employer matches come in shares.

The exemption does not erase fiduciary duty. Under ERISA Section 404(c), if a plan gives participants genuine control over their investment choices and meets certain conditions, fiduciaries get some liability protection when a participant voluntarily loads up on employer stock. Courts have still held fiduciaries liable where they knew the stock was imprudent and failed to act.⁸

The Three-Year Right to Diversify

Federal law gives participants an exit. Under Section 401(a)(35) of the Internal Revenue Code, participants who have completed at least three years of service must be allowed to divest employer securities and reinvest the proceeds in other plan options. The plan must offer at least three alternative investments with materially different risk and return characteristics, and divestment opportunities must be available at least quarterly.⁹

The right extends to beneficiaries of deceased participants and to alternate payees under a qualified domestic relations order. A plan cannot impose restrictions on selling employer stock that it does not also impose on other investments, so a plan that allows daily trading in its bond fund cannot limit employer-stock sales to once a year.

Net Unrealized Appreciation for Concentrated Employer Stock

Participants who do hold large amounts of employer stock in a 401(k) can use the net unrealized appreciation strategy on distribution. NUA is the difference between what the employer stock cost when it went into the plan and its market value at distribution. In a lump-sum distribution, the NUA portion is excluded from ordinary income at the time of the distribution. When the participant later sells the stock, the NUA amount is taxed as a long-term capital gain regardless of how long the shares were held after the distribution.¹⁰

Any appreciation after the stock leaves the plan follows standard capital gains rules: long-term if held more than a year post-distribution, short-term otherwise. NUA only works with a lump-sum distribution, and the stock must move out of the plan in kind rather than being sold inside the plan first. For a participant sitting on heavily appreciated employer stock, the long-term capital gains rate on NUA can be well below the ordinary income rate that would apply to a straight IRA rollover.

1
Office of the Law Revision Counsel. 15 USC 80a-5 – Subclassification of Management Companies
2
Office of the Law Revision Counsel. 26 USC 851 – Definition of Regulated Investment Company
3
eCFR. 17 CFR 270.2a-7 – Money Market Funds
4
Nasdaq Listing Center. Listing Guide – Exchange-Traded Products
5
Nasdaq Listing Center. Nasdaq Rule 5700 Series
6
eCFR. 17 CFR 270.6c-11 – Exchange-Traded Funds
7
Office of the Law Revision Counsel. 29 USC 1107 – Limitation With Respect to Acquisition and Holding of Employer Securities and Employer Real Property by Certain Plans
8
eCFR. 29 CFR 2550.404c-1 – ERISA Section 404(c) Plans
9
Federal Register. Diversification Requirements for Certain Defined Contribution Plans
10
Internal Revenue Service. Notice 98-24 – Net Unrealized Appreciation in Employer Securities