Whether mutual funds are diversified depends on a specific federal legal test, not on marketing language: the Investment Company Act of 1940 defines a “diversified” fund by a mathematical rule often called 75-5-10, and funds that don’t meet it are classified as nondiversified. Passing the test still leaves room for meaningful concentration inside a portfolio, and a separate tax-code test applies to every fund regardless of what it calls itself. So the honest answer is that some mutual funds are diversified in the legal sense, some are not, and even the diversified ones can hold larger single-company positions than most investors assume.
What “Diversified” Legally Means
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 The restriction lives in that last category. Within the 75% bucket, the “other securities” portion is capped at no more than 5% of total assets in any single issuer and no more than 10% of that issuer’s outstanding voting shares. Government securities and other investment company holdings inside the 75% bucket face no per-issuer caps.
The remaining 25% of the portfolio has no comparable per-issuer restriction under this statute. In theory a diversified fund can place a large share of that 25% slice into a single company and still qualify. Many investors assume “diversified” rules out any large single bet; the law actually permits meaningful concentration across up to a quarter of assets.
When Market Gains Push a Position Past 5%
The 5% test applies at the moment a fund buys, not continuously. A stock purchased at 4% of assets can appreciate to 8% and the fund keeps its diversified status, 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 restated this reading, noting 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 consequence in practice: a fund labeled diversified may hold individual positions well above 5% of assets. The label breaks only when a manager buys more of an already oversized position.
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 assets in a single issuer and own more than 10% of a company’s voting stock. Sector funds and certain narrow index funds commonly carry this classification because the 75-5-10 rule would prevent them from concentrating in their target area.
Nondiversified funds must warn investors in the prospectus. SEC Form N-1A requires them to state that they are non-diversified, explain what that means in practical terms, and describe the additional risks that concentration creates.3U.S. Securities and Exchange Commission. Form N-1A For nondiversified funds that means spelling out the possibility that a decline in one or two large positions could disproportionately hurt the fund’s value.
A Fund Can’t Quietly Switch
Changing from diversified to nondiversified requires approval by a majority of the fund’s outstanding voting securities under 15 U.S.C. § 80a-13.4Office of the Law Revision Counsel. 15 USC 80a-13 – Changes in Investment Policy The vote requirement exists because reclassification changes the risk profile of the fund. In 2025, Vanguard asked shareholders of two index funds to approve reclassification from diversified to nondiversified so the funds could track their sector benchmarks more accurately without hitting the per-issuer caps.
Industry Concentration Is a Separate Question
The 75-5-10 rule limits exposure to any single issuer. It does not limit exposure to any single industry. The SEC treats investing 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 75-5-10 perfectly by spreading its holdings across dozens of issuers and still be concentrated because all those issuers operate in the same industry. Every mutual fund must adopt a fundamental policy stating whether it will concentrate in a particular industry, and once that policy is set, changing it also requires a shareholder vote.
The Tax Code Adds Its Own Test
Meeting the 1940 Act’s definition is only half the picture. The Internal Revenue Code imposes its own diversification test that every mutual fund must pass to qualify as a Regulated Investment Company under Subchapter M. A fund that fails this test loses more than a label. It gets taxed like a regular C corporation, which means fund-level income tax on all earnings 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 the same style of per-issuer limits: no more than 5% of assets and no more than 10% of voting securities for any single issuer 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 ceiling is the tax code’s hard cap, and it applies even to the portion of the portfolio the 1940 Act would leave unrestricted.
Failing isn’t immediately fatal. If a position drifts past the limits from market appreciation rather than a new purchase, the fund keeps RIC status. If the breach comes from a purchase, the fund has 30 days after quarter-end to fix it. For failures discovered later, the fund can still preserve RIC status by identifying the assets, showing reasonable cause, and disposing of them within six months.6Office of the Law Revision Counsel. 26 USC 851 – Definition of Regulated Investment Company A fund that can’t cure the failure owes a penalty tax reported on Form 1120-RIC with a statement explaining that the failure was due to reasonable cause and not willful neglect.7Internal Revenue Service. Instructions for Form 1120-RIC
Why “Diversified” on the Label May Not Diversify You
Owning several diversified funds doesn’t guarantee a diversified overall portfolio. Fund 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 put 5% of assets into the same tech company, your personal exposure is far larger than any single fund’s position suggests.
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. “Active share” 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. Checking the top-10 holdings across every fund you own is the fastest way to spot hidden concentration.