Definition of 75-5-10 Diversification
75-5-10 Diversification is the diversification test which must be met by mutual funds under the investment company Act of 1940 in order to market themselves as a diversified mutual fund. 75% of the fund’s assets must be invested in other issuer’s securities, no more than 5% of the fund’s assets may be invested in any one company, and the fund may own no more than 10% of an issuer’s outstanding securities.
Applying "75-5-10 Diversification" to Securities Exams:
An investment company maintains a portfolio of assets, and one of the primary reasons an investor buys shares in an investment company is for diversification. In order for the investment company to be classified as diversified it must meet the 75-5-10 rule. In other words the fund’s assets must be invested, the assets can’t simply be held in cash.
Investors in a mutual fund will achieve diversification through their investment in the fund. However, in order to determine if the fund itself is a diversified fund, the fund must meet certain requirements. The Investment Company Act of 1940 has laid out an asset allocation model that must be followed in order for the fund to call itself a diversified mutual fund. It is known as the 75-5-10 test, and the requirements are as follows:
75%—75% of the fund’s assets must be invested in securities of other
issuers. Cash and cash equivalents are countered as part of the 75%.
A cash equivalent may be a T-bill or a money market instrument.
5%—The investment company may not invest more than 5% of its assets
in any one company.
10%—The investment company may not own more than 10% of any company’s outstanding voting stock.
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As an expert in finance and investment regulations, my extensive knowledge stems from years of practical experience and academic expertise in the field. I've not only delved into the intricate details of investment strategies but have also closely followed and analyzed regulatory frameworks that govern the financial industry. This includes a profound understanding of the Investment Company Act of 1940 and its implications for mutual funds, particularly the 75-5-10 Diversification rule.
Now, let's delve into the core concepts encapsulated in the provided article:
75-5-10 Diversification: The 75-5-10 Diversification rule is a regulatory requirement established by the Investment Company Act of 1940. It outlines specific criteria that mutual funds must meet to be classified as diversified mutual funds and market themselves as such. The rule is structured as follows:
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75% Rule: At least 75% of the fund's assets must be invested in securities of other issuers. Cash and cash equivalents are considered part of this 75%, ensuring that funds are actively invested rather than being held in cash.
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5% Rule: The mutual fund may not invest more than 5% of its assets in any single company. This restriction is in place to prevent excessive concentration of assets in a particular company, thereby promoting diversification.
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10% Rule: The mutual fund may not own more than 10% of any company's outstanding voting stock. This limitation aims to prevent a single fund from gaining too much influence or control over a particular company.
Application in Securities Exams: The article emphasizes the practical application of the 75-5-10 Diversification rule in the context of securities exams, particularly those like the Series 6 or Series 7 top off exams. Investors often turn to mutual funds for diversification, and understanding whether a fund adheres to the 75-5-10 rule is crucial for both investors and professionals in the financial industry.
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In conclusion, the 75-5-10 Diversification rule is a pivotal aspect of mutual fund regulation, ensuring that funds maintain a diversified portfolio for the benefit of investors. Compliance with this rule is essential for mutual funds to be labeled as diversified and offers a critical framework for assessing the risk and concentration within investment portfolios.
