The 5 10 40 rule is a diversification requirement of UCITS products. The term can also styled as “5-10-40 Rule” or “5/10/40 Rule“. Since 1985, the rule has been one of the cornerstones of UCITS products. The rule works as follows
- a UCITS may not invest more than 5% of its net assets in transferable securities or money market instruments issued by the same body
- although this limit can be increased to 10% issued by the same body
- so long as the total value of transferable securities or money market instruments held in issuing bodies in each of which it can invest more than 5% is less than 40%
At the 5% limit, the fund would require a minimum of 20 stocks (or other transferable asset) in the portfolio. If the limit is raised to 10% as per bullet point #2, 4 stocks can be held with a weighting of 10% as they do not exceed the 40% limit as per bullet point #3. The remaining 60% can be filled by a minimum of 12 stocks each at 5%. Thus, the theoretical minimum number of positons in a 5 10 40 rule compliant UCITS fund is 4 + 12 = 16. As to what level of diversification is sufficient depends of the specific assets in question and the broader market or index to which they are being compared. For stocks, the standard deviation of returns declines markedly for a portfolio containing stocks of 15 companies. However, an academic study from 2000 claimed full diversification may not be achieved even when 60 stocks are included.
As with many definitive limit rules however, the 5 10 40 rule created some problems for UCITS. Occasionally, a fund needed to track an index (an index fund) where the weighting of an individual constituent element of the index breached the rule. There was also a grey area where a relationship existed between two or more of the constituent elements of an index. This meant that they were considered as a single issuer, and in an aggregation would occasionally breach the exposure limits. This issue has however been addressed by UCITS III. The diversification rule may also create issues for funds which operate concentrated portfolios such as global macro bets, high-conviction equity strategies or fixed income strategies despite the level of perceived risk associated with these strategies.
Diversification guidelines such as these are a useful tool for traders in their own portfolios. The Merger Arbitrage Limited T20 Portfolio has similar guidelines for its construction. Traders should always be aware of significant build up or concentration of deals in similar industries, of similar size, geographic region or deals requiring approval from the same regulatory body for example.
UCITS
The UCITS fund framework is a consolidated EU Directive and is the guiding regulation for the majority of European regions ETF‘s. UCITS stands for “Undertakings for Collective Investment in Transferable Securities“. This refers to a series of European Union directives in place since 1985. It should be noted however, that certain European funds such as those issued in Switzerland, Sweden and Eastern Europe are not UCITS.
Additional 5 10 40 Rule Analysis
Index providers often adhere to this diversification rule at the index methodology stage. This allows the underlying index to be tracked by a UCITS compliant Mutual fund, Exchange Traded Fund (ETF) or other index fund or tracking fund and minimize the tracking error. It is worth noting however that in addition to the 5 10 40 rule, since UCITS III, a UCITS whose policy is to replicate an index is subject to the 20/35 rule. The fund is permitted to invest up to 20% of its net assets in shares and / or debt securities issued by the same body. This 20% limit can be raised up to 35% in the case of a single issuer where justified by exceptional market conditions. The index must be recognized by a central bank however, and be sufficiently diversified.
