75-5-10 rule. What mutual fund investors must know

Are you a mutual fund investor? If so, do you know the 75-5-10 rule? Well, if not then you must realise by now that understanding how mutual funds are structured and regulated is crucial to making informed investment decisions.

In this article, we will explain what the 75-5-10 rule is, how it is applied and why it matters to you as an investor.

• Table of contents

• Understanding the concept of 75-5-10 rule for mutual funds
• Using the 75-5-10 rule for mutual funds
• Examples of using 75-5-10 rule
• Benefits of using the 75-5-10 rule for investors
• How to choose mutual funds using the 75-5-10 rule?
• Challenges of the 75-5-10 rule
• Factors to consider while using the 75-5-10 rule

Understanding the concept of 75-5-10 rule for mutual funds

The 75-5-10 rule seeks to ensure that equity mutual funds stay diversified. The basic concept and reason to introduce this rule is to ensure that mutual funds are not overly exposed to a few stocks or sectors, which can significantly increase the associated risk.

So, to understand this rule in simplest manner, let’s break the rule into three parts:

• 75% rule: This part means that at least 75% of a mutual fund’s total assets must be invested in other securities such as equities or cash and cash equivalents such as Treasury bills.
• 5% rule: This part means that a mutual fund scheme cannot invest more than 5% of its assets in shares of any single company.
• 10% rule: The fund can invest only up to 10% of its assets in any company’s outstanding voting stock.

In short, this rule makes sure that no single company or small group of companies takes up too much of the mutual fund’s portfolio. It’s a way to encourage diversification and limit risks.

Using the 75-5-10 rule for mutual funds

Fund managers are mainly responsible for applying this rule while creating or managing a mutual fund portfolio. Here’s how the rule is used in practice:

Creating a diversified portfolio

When a mutual fund is built, fund managers pick different stocks from various sectors. The 75% rule ensures they stick to investing securities of other companies or cash and cash equivalents. This is to ensure that the majority of the fund’s investments are in stable and well-performing assets.

Avoiding overexposure to a single stock

Fund managers regularly check the portfolio to make sure the allocations do not exceed more than 5% in a single company’s stock. If the value of a particular stock increases too much and crosses the 5% limit, the fund manager may sell a portion to stay within the rule.

Monitoring outstanding voting stock

No matter how reputable a company is, investing more than 10% of the fund’s total money in any company’s outstanding voting stock is not allowed. This mitigates risks associated with investing heavily in a single company’s outstanding voting stock as investors with voting rights may influence a company’s operations.

Examples of using 75-5-10 rule

Creating a new equity fund

Imagine a fund has Rs. 100 crore to invest. According to the 75-5-10 rule:
The fund must invest at least Rs. 75 crore in equities. This is the 75% rule.
It can invest a maximum of Rs. 10 crore in any company’s outstanding voting stock. That’s the 10% rule.
It can invest only up to Rs. 5 crore in the largest holding company. That’s the 5% rule.

Also Read: The 8-4-3 Rule in Mutual Funds

Benefits of using the 75-5-10 rule for investors

Diversification

The rule ensures that your money is spread across many companies. This mitigates the impact of one company performing badly.

Risk management

By limiting investments in any one company, the rule keeps the fund from being too dependent on a single stock. This mitigates the risk of major losses.

Stable long-term growth

A diversified fund is less likely to face huge ups and downs. This makes it more suitable for long-term goals like retirement or education.

Transparency

When you know how much is allocated to each asset then you can be more confident about the transparency of the fund.

How to choose mutual funds using the 75-5-10 rule?

• Check the portfolio diversification: Look at the fund’s factsheet or portfolio details. See if the top holdings are well spread out.
• Look at sector exposure: Make sure the fund is not putting too much money in one sector like banking or technology.
• Review the top 10 holdings: If one company takes up more than 5% of the fund, that’s a red flag. It may not be following the rules properly.

Challenges of the 75-5-10 rule

Limited exposure to high performers: Sometimes a single stock may be doing very well. But due to the 5% limit, the fund cannot take full advantage of its growth.

• Frequent rebalancing: Prices of stocks change daily. Fund managers have to keep checking and rebalancing, which can increase costs.
• Restricts thematic funds: Some funds that focus on one sector (like IT or pharma) may struggle to meet this rule without losing their theme.
• Lower returns: Funds that follow the 75-5-10 rule may yield comparatively lower returns due to restricted allocation of investment.

Factors to consider while using the 75-5-10 rule

• Investment objective: Are you looking for growth, income or safety? Choose a fund that aligns with your goal.
• Time horizon: The longer you can stay invested, the more you can benefit from equity mutual funds.
• Risk tolerance: Even with this rule, equities can be volatile. Make sure you are comfortable with some ups and downs.
• Fund performance: Check past returns, but don’t rely on them alone. Look at consistency over time.
• Expense ratio: Lower expense ratios mean you get to keep more of your returns.
• Fund manager experience: An experienced manager is more likely to follow the rules wisely and take better decisions.

Conclusion

The 75-5-10 Rule for Mutual Funds is a key part of the Indian mutual fund industry. It acts like a safety net that protects investors from overexposure and mitigates risk by mandating diversification.

Also Read: The Rule of 72

FAQs:

What is the 75-5-10 rule in mutual funds?

At least 75% of the fund’s money be invested in other securities such as equities or cash and cash equivalents. No more than 5% in any one company. No more than 10% in holdings of the company's outstanding voting stocks.

Why is the 75-5-10 rule important for mutual funds?

It helps keep mutual funds diversified and lowers the risk of over-relying on one or two companies. This cushions investors from major downturns due to sudden drops in individual stocks.

How does the 75-5-10 rule promote diversification?

By setting limits on how much can be invested in one stock, the rule ensures that the fund’s money is spread out across many companies and sectors. This mitigates overall risk.

What types of assets are included in the 75% portion of the rule?

The 75% portion must be invested in equity shares or cash and cash equivalents. These are the stocks of companies listed on stock exchanges.

Can a mutual fund still be considered diversified if it does not adhere to the 75-5-10 rule?

Not really. If a mutual fund doesn’t follow this rule, it may not be classified as a diversified equity fund and could be considered high-risk due to lack of diversification.